1. shopping
2. resources
3. consumer protection

This page intentionally left blank
HOW TO PROTECT INVESTORS
As governments around the world withdraw from welfare provision and
promote long-term savings by households through the financial markets,
the protection of retail investors has become critically important. Taking
as a case study the wide-ranging EC investor-protection regime which now
governs EC retail markets after an intense reform period, this critical, contextual and comparative examination of the nature of investor protection
explores why the retail investor should be protected, whether retail investor
engagement with the markets should be encouraged and how investorprotection laws should be designed, particularly in light of the financial
crisis. The book considers the implications of the EC’s investor-protection
rules ‘on the books’ but also considers investor-protection law and policy
‘in action’, drawing on experience from the UK retail market and in particular the Financial Services Authority’s extensive retail market activities,
including the recent Retail Distribution Review and the Treating Customers
Fairly strategy.
niamh moloney is a professor in the Law Department of the London
School of Economics and Political Science.
international corporate law and
financial market regulation
Recent years have seen an upsurge of change and reform in corporate law and
financial market regulation internationally as the corporate and institutional
investor sector increasingly turns to the international financial markets. This
follows large-scale institutional and regulatory reform after a series of
international corporate governance and financial disclosure scandals exemplified
by the collapse of Enron in the US. There is now a great demand for analysis in
this area from the academic, practitioner, regulatory and policy sectors.
The International Corporate Law and Financial Market Regulation series will
respond to that demand by creating a critical mass of titles which will address the
need for information and high-quality analysis in this fast developing area.
Series Editors
Professor Eilis Ferran, University of Cambridge
Professor Niamh Moloney, London School of Economics and Political Science
Professor Howell Jackson, Harvard Law School
Editorial Board
Professor Marco Becht, Professor of Finance and Economics at Universit´e Libre
de Bruxelles and Executive Director of the European Corporate Governance
Institute (ECGI).
Professor Brian Cheffins, S. J. Berwin Professor of Corporate Law at the Faculty
of Law, University of Cambridge.
Professor Paul Davies, Cassel Professor of Commercial Law at the London
School of Economics and Political Science.
Professor Luca Enriques, Professor of Business Law in the Faculty of Law at the
University of Bologna.
Professor Guido Ferrarini, Professor of Law at the University of Genoa and
Honorary Professor, Faculty of Law, University College London.
Professor Jennifer Hill, Professor of Corporate Law at Sydney Law School.
Professor Klaus J. Hopt, Director of the Max Planck Institute of Comparative
and International Private Law, Hamburg.
Professor Hideki Kanda, Professor of Law at the University of Tokyo.
Professor Colin Mayer, Peter Moores Professor of Management Studies at the
Sa¨ıd Business School and Director of the Oxford Financial Research Centre.
James Palmer, Partner of Herbert Smith, London.
Professor Michel Tison, Professor at the Financial Law Institute of the University
of Ghent.
Andrew Whittaker, General Counsel to the Board at the UK Financial Services
Authority.
Professor Eddy Wymeersch, Chairman of the Committee of European Securities
Regulators (CESR); Co-Chair of the CESR-European Central Bank Working
Group on Clearing and Settlement, and part-time Professor of Commercial Law,
University of Ghent.
HOW TO PROTECT INVESTORS
Lessons from the EC and the UK
NIAMH MOLONEY
CAMBRIDGE UNIVERSITY PRESS
Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore,
São Paulo, Delhi, Dubai, Tokyo
Cambridge University Press
The Edinburgh Building, Cambridge CB2 8RU, UK
Published in the United States of America by Cambridge University Press, New York
www.cambridge.org
Information on this title: www.cambridge.org/9780521888707
© Niamh Moloney 2010
This publication is in copyright. Subject to statutory exception and to the
provision of relevant collective licensing agreements, no reproduction of any part
may take place without the written permission of Cambridge University Press.
First published in print format 2010
ISBN-13
978-0-511-67557-7
eBook (NetLibrary)
ISBN-13
978-0-521-88870-7
Hardback
Cambridge University Press has no responsibility for the persistence or accuracy
of urls for external or third-party internet websites referred to in this publication,
and does not guarantee that any content on such websites is, or will remain,
accurate or appropriate.
To Iain
CONTENTS
Preface and acknowledgments
Table of cases
xvii
Table of treaties and legislation
List of abbreviations
xxv
1
I.
II.
III.
IV.
The retail investor and the EC
page xiii
xviii
1
The importance of the retail markets
1
The retail markets and the EC
5
1. The development of a retail market agenda
5
2. Scope: the reach of EC investor protection law and policy
13
3. Beyond the cross-border context
18
4. But room for local ‘law on the books’ and for ‘law in action’: the
UK example
22
5. Examining retail investor protection through the EC lens
29
Who is the EC investor?
30
1. Characterizing the target of investor protection
30
2. The average EC investor: an elusive target?
31
3. Investors or consumers?
39
The financial crisis and EC retail market policy
41
2
Designing a retail investor protection regime
I.
Why intervene in the retail markets? Encouraging the empowered
investor, shielding the irrational investor or supporting the trusting
investor?
45
1. Characterizing investor protection
45
2. The retail investor as an agent of public policy and the
empowered investor
47
3. The irrational and uninformed investor
67
4. The trusting investor
81
The risks of retail market intervention
92
1. Regulatory and retail market agenda risks
92
II.
vii
45
viii
contents
III.
2. Regulation and the retail markets: ‘laws on the books’ and ‘laws in
action’
95
3. Responding to the drivers of retail market engagement
97
4. Centralization risks
100
How to intervene on the retail markets?
102
1. The regulatory toolbox and self-regulation
102
2. Achieving retail market outcomes
106
3. Principles-based regulation and the retail markets
108
4. Evidence-based policy formation and rule-making
114
5. Controlling risk-taking and segmentation techniques
118
6. Diversification
122
3
Product regulation
I.
Product regulation and the retail markets
134
1. The EC and product regulation
134
2. The benefits of CIS product regulation
137
3. The risks of CIS product regulation
142
4. An integrated model
151
The UCITS investor protection regime and product regulation
152
1. Inbuilt diversification and liquidity
152
2. Inbuilt governance: the depositary and the management
company
153
The UCITS III product and design risks
157
1. The UCITS III regime
157
2. UCITS III and the risks of facilitative product design
162
3. Beyond UCITS III: alternative investments and product
design risks
168
4. Beyond product regulation: the product provider and the
provider/distributor relationship
176
Structured and substitute products
179
1. The substitute product market and structured products
179
2. A segmented product regime and its risks
184
3. Developing a response
187
II.
III.
IV.
134
4
Investment advice and product distribution
I.
Intermediation, its risks and regulation
192
1. The benefits of advice
192
2. The risks
193
3. Regulating advice
196
Scope of the advice and product distribution regime
200
1. The advice and distribution regime
200
2. MiFID’s scope: a wide range of instruments and services
II.
192
202
contents
ix
3. MiFID’s scope: the pivotal investment advice definition
203
4. MiFID’s scope: supporting access to advice?
204
5. MiFID’s scope: the nature of investor protection ‘on the books’
207
III. Regulatory design choices
209
1. Regulatory design choice (1): maximum harmonization
209
2. Regulatory design choice (2): principles-based regulation
212
3. Regulatory design choice (3): shaping firm conduct and the
eclipsing of disclosure
213
IV. Regulatory technique (1): the fairness principle and ‘law in action’
215
1. The fair treatment principle
215
2. The risks of ‘fairness’
217
3. Fairness and the TCF model: ‘law in action’
219
4. The implications of the TCF model
223
V. Regulatory technique (2): marketing risks
224
1. Marketing risks
224
2. Delivery-specific protection: online and distance contacts
226
3. Horizontal protection: consumer protection directives
227
4. Investment-specific protections: MiFID
231
VI. Regulatory technique (3): quality of advice and suitability
235
1. Suitability and objective advice
235
2. The suitability regime: suitability and appropriateness
237
3. Suitability ‘in action’
240
VII. Regulatory technique (4): conflict-of-interest management
244
1. Conflict-of-interest risks
244
2. MiFID and retail market conflict-of-interest risk
245
VIII. Regulatory technique (5): the investment firm/investor contract
247
IX. Segmentation risks
250
1. The UCITS regime
250
2. Structured and substitute products
252
X. Advice or sales? Addressing the ‘right risks’
256
1. Delivering high-quality investment advice
256
2. Incentive and commission risks: advice or sales?
257
3. MiFID and commission risk
263
XI. Fee-based investment advice: segmenting regulated advice
266
1. Delivering independent investment advice: the UK Retail
Distribution Review and other international experience
266
2. An EC model?
273
XII. Access to mass market advice and the sales problem
278
1. Access to advice
278
2. A mass market advice regime and MiFID: generic advice
279
3. Access to advice and the UK experience
279
4. The EC and access to advice
285
x
contents
5
Disclosure
I.
Disclosure and EC investor protection
288
1. The retail market disclosure regime
288
2. The investor understanding problem
290
3. The risks of disclosure
296
4. Disclosure ‘in action’
300
Investment product disclosure (1): the UCITS regime
304
1. Designing CIS disclosure: the challenge
304
2. The EC laboratory
312
Investment product disclosure (2): the substitute products
challenge
322
1. A fragmented regime
322
2. Developing a response
330
Disclosure in the distribution and advice context
333
1. Marketing communications
333
2. General investment firm and services disclosure: MiFID
Article 19(2) and (3)
334
3. Conflicts of interest and commissions
337
II.
III.
IV.
288
6
The trading process
I.
Promoting access to trading
345
1. Better diversification and lower trading costs
2. The risks and execution-only services
350
Investor protection in the trading process
354
1. A matrix of rules
354
2. Best execution
355
3. Trading and issuer disclosure
363
II.
345
345
7
Education and governance
I.
Investor education
374
1. Investor education
374
2. Building an investor education strategy: the UK example
384
3. Investor education and EC retail market policy
389
Retail investor involvement in policy formation and law-making
398
1. Retail investor involvement
398
2. Retail governance and the EC
399
3. Improving investor governance
413
4. CESR and the retail markets
419
II.
374
8
Supervision, enforcement and redress
I.
Public supervision and enforcement in the retail markets
1. Public supervision and enforcement in the retail markets
426
426
426
contents
II.
2. The EC regime
426
3. Risks to the retail markets
429
4. CESR, the retail markets and supervisory convergence
5. Investor compensation schemes
440
Investor redress
442
1. Access to justice and the retail investor
442
2. Direct retail investor action
444
3. Collective action
458
Index
464
xi
436
PREFACE AND ACKNOWLEDG MENTS
This book is concerned with the protection of retail or household investors.
The retail markets can be something of a Cinderella in financial market
regulation. The regulatory challenges can be humdrum but intractable, the
retail constituency quiescent and unhelpful to the beleaguered regulator,
and the empirical and analytical pyrotechnics of law and finance and of
law and economics, typically applied to financial market regulation, often
overlook this area; behavioural finance is, however, now taking up some
of the empirical heavy lifting. But, as governments withdraw from welfare
provision and promote stronger long-term household saving, the retail
markets have become of central importance; to borrow a phrase from law
and finance, they ‘matter’. So does investor protection regulation and how
it is developed and designed.
This book accordingly addresses three questions. Who is the retail
investor (chapter 1)? Why should that investor be protected (chapter 2)?
How should protection be designed (chapters 3–8)? It considers whether
investors are best characterized as empowered, irrational or trusting, and
considers the implications for regulatory design. Its case study is the massive EC harmonized regulatory regime for Member States’ retail investment markets which provides a rich case study of investor protection law
‘on the books’. But effective retail market protection depends heavily on
‘law in action’, which remains largely the preserve of the Member States.
The book’s main case study for domestic ‘law in action’ is the UK and, in
particular, the retail market activities of the Financial Services Authority.
A note on the European terminology used is necessary. The book is
largely concerned with the internal market aspect of the European Union
and so generally refers to the European Community, the EC and the EC
Treaty. At the time of writing, the Lisbon Treaty had not been ratified by all
the Member States. If the Treaty comes into force, the relevant EC Treaty
provisions will not change in substance, but will be incorporated into the
new Treaty on the Functioning of the European Union, and references to
xiii
xiv
preface and acknowledgments
the EC or European Community in this book should be read as references
to the EU or European Union.
This book entered its final stages against the backdrop of the financial
crisis. In the maelstrom, as regulatory and governmental attention focused
on safety and stabilization, retail investor interests have been largely overshadowed. Household wealth has, however, been destroyed, investor trust
has been badly shaken and the policy drive to encourage stronger marketbased saving seems quixotic, at least at first glance. Nonetheless, as this
book argues, the difficult task of designing an effective investor protection system and of supporting household engagement with the markets
must go on. Much greater evidence is needed on how investors think
and behave (chapter 2). Hard questions concerning the degree to which
investors should be allowed to access more complex products must be
answered, particularly given the losses related to structured products over
the crisis (chapter 3). Disclosure, the great panacea of modern investor
protection, seems all the more a troublesome device (chapter 5). As discussed in chapter 7, the voice of the retail investor, however ill-informed
and erratic that voice may be, has been largely absent from the policy
debate on the crisis. This must change.
The book aims to state the law and major policy developments as at
31 May 2009 although it has been possible to make some very brief references to subsequent major developments. A number of these are revealing as to the direction of the policy debate on retail investor protection.
Most notably, perhaps, the Obama Administration’s blueprint for regulatory reform (Department of the Treasury, Financial Regulatory Reform
(2009)), which took as a key objective the protection of consumers and
investors from financial abuse, includes significant institutional reform in
the form of a new Consumer Financial Protection Agency which will share
responsibility with the Securities and Exchange Commission for protecting consumers of financial services. From an EC perspective, much can
be learned from the emphasis being placed on the Agency’s gathering of
‘actual data about how people make financial decisions’. Otherwise, there
is dishearteningly little evidence of any attempts to gather meaningful data
on how household investors reacted to the crisis; the European Commission’s 2009 Eurobarometer survey on the crisis was limited to a survey
of reaction to the EU’s general efforts (Standard Eurobarometer (EB 71),
Europeans and the Economic Crisis (2009)).
Institutional reform has also been a major theme of the EC response
to the crisis, although here the retail interest was not the driving factor
(chapter 7). The Commission’s September 2009 proposals for a European
preface and acknowledgments
xv
System of Financial Supervisors and, in particular, for a central European
Securities and Markets Authority (which followed the Commission’s May
2009 Communication on supervision and the agenda-setting de Larosi`ere
Report) promise much for better pan-EC prudential supervision. But the
impact on retail market law-making is not yet clear, although the proposed Authority will have the power to adopt binding technical standards
(endorsed by the Commission). Some efforts are, however, being made
to engage the retail sector with the Authority’s work through enhanced
consultation procedures (via a Stakeholders Group). The proposed Joint
Committee of European Supervisory Authorities may also lead to better
cross-sectoral law-making, although institutional segmentation between
the banking, insurance/pensions and securities sectors persists in the new
model. The initial failure to engage with the retail sector during the important de Larosi`ere discussions remains disheartening (chapter 7). The crisis
has, however, galvanized FIN-USE, the EC’s forum for the consumer interest in financial services, to produce a number of papers, significant by their
very adoption, on the crisis (including FIN-USE, The Future of Financial
Services Supervision (2009)). Otherwise, and perhaps reassuringly given
persistent governance and evidence-gathering weaknesses, there was little
in the way of knee-jerk reaction, with the 2009 Commission Communication on the treatment of substitute investment products emerging
from a discussion which pre-dated the crisis, although the crisis may have
encouraged the Commission to adopt what is a relatively radical reform
agenda.
Similarly, in the UK, prudential and stability matters have been to the
fore, although the FSA did proceed with the next stage of its massive
Retail Distribution Review in June 2009, presenting specific reform proposals designed to address persistent and entrenched conflicts of interest
in the commission-based UK investment advice and product distribution
industry (Consultation Paper 09/18). The proposals broadly reflect the
FSA’s final thinking on the Review in 2008 (chapter 4). Investment advice
concerning a broad range of substitute ‘retail investment products’ will be
segmented into ‘independent advice’ and ‘restricted advice’. ‘Independent
advice’ must be unbiased, unrestricted and based on a comprehensive
and fair analysis of the relevant investment product market. Advice must
otherwise be labelled as ‘restricted’, including where a firm advises only
on proprietary products. A new adviser charging model will apply to all
investment advice; the current commission-based system will be prohibited. A new professional standards regime for all investment advice will
also be adopted.
xvi
preface and acknowledgments
Overall, however, there is little evidence of a policy concern, post-crisis,
to rethink how investor protection is delivered. The dominant assumptions
concerning investor empowerment, investor competence and the investor’s
carrying of market risk remain in place.
The completion of this book was supported by a Research Leave Award
from the Arts and Humanities Research Council which I very gratefully acknowledge. Cambridge University Press, in particular Kim Hughes
and Daniel Dunlavey, oversaw the book’s production with great courtesy and efficiency. I would also like to thank the many people from
whose work I have learned; in particular, I owe a great deal to Professors Eil´ıs Ferran, Guido Ferrarini, Klaus Hopt, Howell Jackson, Donald
Langevoort, Stephen Weatherill and Eddy Wymeersch, whose scholarship
has inspired me.
My greatest inspiration is my wonderful husband, Iain. This book is
dedicated to him.
Niamh Moloney
1 October 2009
TABLE OF CASES
Alpine Investments BV v. Minister van Financi¨en [1995] ECR I-1141 (Case C-384/93)
91, 233
Antonio Testa and Lido Lazzeri v. Commissione Nazionale per la Societ`a e la Borsa
(Consob) [2002] ECR I-10797 (Case C-365/00) 17
Commission of the European Communities v. Federal Republic of Germany [1986]
ECR 3755 (Case 205/84) 91
Gut Springenheide GmbH and Rudolf Tusky v. Oberkreisdirektor des Kreises
Steinfurt – Amt f¨ur Lebensmittel¨uberwachung [1998] ECR I-4657 (Case C-210/96)
92, 115
Est´ee Lauder Cosmetics GmbH & Co. OHG v. Lancaster Group GmbH [2000] ECR
I-117 (Case C-220/98) 92
Soci´et´e Civile Immobili`ere Parodi v. Banque H. Albert de Bary et Cie [1997] ECR
I-3899 (Case C-222/95) 91
Verein gegen Unwesen in Handel und Gewerbe K¨oln eV v. Mars GmbH [1995] ECR
I-1923 (Case C-470/93) 446
xvii
TABLE OF TREATIES AND LEG ISLATION
EC Treaty and EC legislation
EC Treaty
Art. 3 . . .
5
Art. 5 . . .
10
Art. 10 . . .
446
Art. 14 . . .
5
Art. 43 . . .
5
Art. 44(2)(g) . . .
10
Art. 47(2) . . .
10
Art. 49 . . .
5
Art. 55 . . .
10
Art. 56 . . .
5
Art. 94 . . .
10
Art. 95 . . .
10
Art. 153(1) . . .
391
Art. 251 . . .
405
Art. 257 . . .
405
Consolidated Life Assurance Directive 2002/83/EC . . .
323
Deposit Guarantee Directive 1994/19/EC . . .
42, 442
Distance Marketing of Financial Services Directive 2002/65/EC . . .
201, 226, 228, 233, 249, 255, 289
Art. 3(1) . . .
Art. 3(4) . . .
Art. 12 . . .
Art. 13 . . .
Art. 14 . . .
Art. 15 . . .
8, 14, 21, 40, 57,
450
450
209
459
454
445
E-Commerce Directive 2000/31/EC . . .
7, 227, 334
Injunctions in the Consumer Interest Directive 1998/27/EC . . .
xviii
459, 460
table of treaties and legislation
Art. 2 . . .
Art. 4 . . .
Art. 5 . . .
xix
459
459
459
Insurance Mediation Directive 2002/92/EC . . .
Art. 12(1) . . .
Art. 12(2) . . .
Art. 12(3) . . .
16, 201, 236, 253, 255, 276, 339
253, 339
254
254
Investment Services Directive 1993/22/EC . . .
7, 203
Investor Compensation Schemes Directive 1997/9/EC . . .
42, 63, 441, 442
Legal Aid Directive 2002/8/EC . . .
447
Market Abuse Directive 2003/6/EC . . .
364, 366, 369, 403
Art. 6 . . .
364
Art. 6(3) . . .
364
Markets in Financial Instruments Directive (MiFID) 2004/39/EC . . .
10, 13, 14, 15,
17, 19, 22, 24, 25, 27, 52, 57, 89, 102, 106, 110, 111, 112, 113, 114, 126, 130, 132, 133,
151, 186, 190, 195, 199, 200, 201, 202, 203, 204, 207, 209, 213, 223, 233, 236, 241, 252,
253, 254, 255, 256, 263, 265, 272, 286, 288, 293, 295, 315, 346, 357, 388, 389, 409, 419,
445, 450
Art. 1 . . .
13
Art. 2(1)(c) . . .
203
Art. 2(1)(h) . . .
201
Art. 2(1)(j) . . .
203
Art. 2(2) . . .
441
Art. 3 . . .
206, 275, 286
Art. 3(2) . . .
335
Art. 4(1)(4) . . .
203
Art. 5 . . .
13
Art. 5(5) . . .
276
Art. 6 . . .
207
Art. 7 . . .
207, 276
Art. 7(2) . . .
207
Art. 11 . . .
207
Art. 12 . . .
207
Art. 13 . . .
348
Art. 13(3) . . .
245
Art. 13(7) . . .
207
xx
table of treaties and legislation
Art. 13(8) . . .
207
Art. 18 . . .
245, 348, 353
Art. 18(1) . . .
245
Art. 18(2) . . .
245, 338
Art. 19 . . .
207, 209, 348
Art. 19(1) . . .
115, 213, 215, 216, 217, 220, 221, 230, 234, 236, 240, 245, 249, 263,
264, 354, 359
Art. 19(2) . . .
115, 213, 215, 230, 231, 233, 234, 254, 324, 326, 327, 335, 339, 341,
342
Art. 19(3) . . .
215, 230, 324, 325, 326, 334, 335, 339, 341, 342, 357
Art. 19(4) . . .
215, 237
Art. 19(5) . . .
127, 215, 237, 239
Art. 19(6) . . .
120, 126, 128, 215, 353
Art. 19(7) . . .
215, 249
Art. 19(8) . . .
215, 336
Art. 21 . . .
348, 355
Art. 21(1) . . .
356
Art. 21(2) . . .
356
Art. 21(3) . . .
356, 359
Art. 22(1) . . .
215
Art. 22(2) . . .
349
Art. 27 . . .
349
Art. 32(7) . . .
427, 435
Art. 48 . . .
428
Art. 50 . . .
428
Art. 51 . . .
429
Art. 52 . . .
459
Art. 53 . . .
454
Art. 56 . . .
428
Art. 57 . . .
428
Art. 58 . . .
428
Art. 59 . . .
428
Art. 62 . . .
427
MiFID Level 2 Directive 2006/73 . . . 15, 17, 200, 203, 207, 209, 215, 238, 245, 263, 315
Art. 4 . . .
Art. 4(1) . . .
Art. 5 . . .
Art. 6 . . .
Art. 7 . . .
Art. 8 . . .
102, 210, 211, 247, 273, 278, 328, 329
15, 203
207
207
207
207
table of treaties and legislation
Art. 9 . . .
207
Art. 10 . . .
207, 447
Art. 11 . . .
207
Art. 12 . . .
207
Art. 13 . . .
207, 348
Art. 14 . . .
207
Art. 15 . . .
207
Art. 16 . . .
207
Art. 17 . . .
207
Art. 18 . . .
207
Art. 19 . . .
207
Art. 20 . . .
207
Art. 21 . . .
263
Art. 22 . . .
263, 264
Art. 22(4) . . .
338
Art. 23(3) . . .
338
Art. 26 . . .
216, 264, 334
Art. 26(b) . . .
342
Art. 27 . . .
216, 231
Art. 27(2) . . .
231, 232
Art. 27(3) . . .
232, 325
Art. 27(4) . . .
232, 325
Art. 27(5) . . .
232, 325
Art. 27(6) . . .
232, 325
Art. 27(7) . . .
232
Art. 27(9) . . .
232
Art. 29 . . .
334
Art. 29(1) . . .
335
Art. 29(2) . . .
335
Art. 29(4) . . .
325, 335
Art. 29(8) . . .
232
Art. 30 . . .
334, 336, 338
Art. 30(1)(h) . . .
340
Art. 30(2) . . .
336
Art. 30(3) . . .
336
Art. 31 . . .
216, 334, 336
Art. 31(1) . . .
325
Art. 31(2) . . .
325
Art. 31(5) . . .
326
Art. 32 . . .
334, 336
Art. 33 . . .
326, 334, 340
Art. 34 . . .
216, 334
xxi
xxii
table of treaties and legislation
Art. 35(1) . . .
219
Art. 35(5) . . .
238
Art. 38 . . .
126
Art. 38(d) . . .
289
Art. 41 . . .
336
Art. 42 . . .
336
Art. 43 . . .
336
Art. 44(1) . . .
356
Art. 44(3) . . .
357
Art. 44(4) . . .
357
Art. 46(2) . . .
359
Art. 51 . . .
207
Art. 52 . . .
203
Prospectus Directive 2003/71/EC . . .
369, 444
9, 13, 52, 119, 120, 129, 289, 323, 363, 366,
Art. 5(1) . . .
370
Art. 5(2) . . .
445
Art. 6 . . .
364
Art. 6(1) . . .
444
Art. 6(2) . . .
444
Art. 13 . . .
324
Art. 14 . . .
324
Art. 14(2) . . .
366
Art. 19 . . .
370
Prospectus Regulation 2004/809
Art. 24 . . .
370
Transparency Directive 2004/109/EC . . .
Art. 4 . . .
Art. 5 . . .
Art. 6 . . .
Art. 9 . . .
Art. 10 . . .
Art. 11 . . .
Art. 12 . . .
Art. 13 . . .
Art. 14 . . .
364
364
364
364
364
364
364
364
364
13, 364, 366, 369, 444
table of treaties and legislation
Art. 15
Art. 16
Art. 20
Art. 21
Art. 22
...
...
...
...
...
xxiii
364
364
369
367
367
Undertakings for Collective Investment in Transferable Securities (UCITS) Directive
1985/611/EC . . .
7, 26, 121, 122, 126, 128, 134, 135, 142, 146, 149, 151, 152, 153,
156, 162, 163, 168, 176, 188, 189, 246, 250, 295, 302, 321
Art. 1 . . .
13
Art. 1(1) . . .
152
Art. 1(2) . . .
158
Art. 1(3) . . .
153
Art. 4 . . .
152
Art. 4(2) . . .
154
Art. 4(3) . . .
155
Art. 5 . . .
156
Art. 19 . . .
158
Art. 19(6) . . .
166, 167
Art. 27(1) . . .
313
Art. 28 . . .
313
Art. 28(1) . . .
314
Art. 28(2) . . .
313
Art. 28(3) . . .
312, 314
Art. 32 . . .
313
Art. 33 . . .
313
Art. 37(1) . . .
152
Art. 42 . . .
159
Art. 44 . . .
250, 426
Art. 44(2) . . .
250
Art. 47 . . .
313
Art. 49 . . .
428
Art. 52 . . .
427
Art. 77 . . .
251
Art. 79 . . .
445
Art. 91 . . .
427
Art. 97 . . .
427, 428
Art. 98 . . .
428
Art. 99 . . .
429
Art. 108 . . .
427
Sched. A . . .
313
xxiv
Sched. B . . .
Sched. C . . .
table of treaties and legislation
313
314
Unfair Commercial Practices Directive 2005/29/EC . . .
227, 255, 290
13, 14, 40, 106, 201, 216,
Annex I . . .
230
Art. 2(c) . . .
228
Art. 2(d) . . .
228
Art. 3(1) . . .
228
Art. 3(9) . . .
14
Art. 5 . . .
40, 228
Art. 6 . . .
106, 229
Art. 7 . . .
229
Art. 7(1) . . .
229
Art. 7(2) . . .
230
Art. 8 . . .
229
Art. 9 . . .
229
Art. 10 . . .
106, 459
Art. 11 . . .
459
Unfair Contract Terms Directive 1993/13/EC . . .
Art. 3(1) . . .
Art. 7(2) . . .
13, 216, 248, 249, 445
249
459
UK legislation
Financial Services and Markets Act 2000 . . .
22, 26, 50, 54, 63, 255, 402
s. 2 . . .
50
s. 5(1) . . .
54
s. 21 . . .
23
s. 22(1) . . .
22
s. 59 . . .
23
US legislation
Investment Advisers Act 1940 . . .
Securities Exchange Act 1934 . . .
267
267
ABBREV IATIONS
3L3
ADR
AFM
AMF
APCIMS
ASIC
BaFIN
CDO
CEBS
CEIOPS
CESR
CFD
CIS
CNMV
COBS
CONSOB
DMD
ECOFIN
ECON
ECOSOC
EEA
EFAMA
ESC
ESME
FESE
FIN-NET
three Level 3 Committees (CESR, CEBS and CEIOPS)
alternative dispute resolution
Autoriteit Financi¨ele Markten (Dutch regulator)
Autorit´e des March´es Financiers (French regulator)
Association of Private Client Investment Managers
Australian Securities and Investments Commission
Bundesanstalt f¨ur Finanzdienstleistungsaufsicht (German
regulator)
collateralized debt obligation
Committee of European Banking Supervisors
Committee of European Insurance and Occupational
Pensions Supervisors
Committee of European Securities Regulators
contract for difference
collective investment scheme
´ Nacional del Mercado de Valores (Spanish
Comision
regulator)
Conduct of Business Sourcebook
Commissione Nazionale per le Societ`a e la Borsa (Italian
regulator)
Distance Marketing of Financial Services Directive
Economic and Financial Affairs Council
European Parliament Committee on Economic and
Monetary Affairs
European Economic and Social Committee
European Economic Area
European Fund and Asset Management Association
European Securities Committee
European Securities Market Expert Group
Federation of European Securities Exchanges
Financial Dispute Resolution Network
xxv
xxvi
FIN-USE
FINRA
FoHF
FOS
FSA
FSAP
FSCG
FSCP
FSMA
ICMA
ICSA
IDD
IMD
IOSCO
ISA
ISD
ISDA
KFD
KID
KII
MiFID
MPBR
MTF
NASD
NAV
NURS
OAM
OECD
OTC
PwC
RDR
RSP
SCDD
SEC
TCF
TER
UCITS
UCP
list of abbreviations
Forum of User Experts in the Area of Financial Services
Financial Industry Regulatory Authority
fund of hedge funds
Financial Ombudsman Service
Financial Services Authority (UK regulator)
Financial Services Action Plan
Financial Services Consumer Group
Financial Services Consumer Panel
Financial Services and Markets Act 2000
International Capital Market Association
Institute of Chartered Secretaries and Administrators
Initial Disclosure Document
Insurance Mediation Directive
International Organization of Securities Commissions
Individual Savings Account
Investment Services Directive
International Swaps and Derivatives Association
Key Features Document
Key Information Document
Key Investor Information
Markets in Financial Instruments Directive
more-principles-based regulation
multilateral trading facility
National Association of Securities Dealers
net asset value
Non-UCITS Regulated Scheme
officially appointed storage mechanism
Organization for Economic Co-operation and
Development
over the counter
PricewaterhouseCoopers
Retail Distribution Review
retail service provider
Services and Costs Disclosure Document
Securities and Exchange Commission (US regulator)
Treating Customers Fairly
Total Expense Ratio
Undertakings for Collective Investment in Transferable
Securities
Unfair Commercial Practices Directive
1
The retail investor and the EC
I. The importance of the retail markets
This book examines the nature of retail investor protection. It considers the
protections which do, and those which should, apply to individual, private
investors1 who purchase investment products, take investment advice,
carry out direct trading and, overall, engage in short-term speculation or
long-term savings through market-based instruments.2
Its case study is the massive EC regulatory regime for the retail investment markets. This regime has grown exponentially in recent years and
now dictates the nature of retail investor protection ‘on the books’ for the
twenty-seven Member States of the European Union. But, as discussed
throughout the book, retail market protection is not simply a function of
‘law on the books’. Effective retail market protection depends heavily on
‘law in action’.3 And ‘law in action’, in terms of, for example, innovative
supervisory strategies, product design initiatives, retail market research,
investor redress and investor education, is largely the preserve of the Member States. The book’s main case study for domestic ‘law in action’ is the
UK and the Financial Services Authority’s increasingly strenuous efforts in
the retail markets.4 But the book adopts a generally comparative approach,
1
2
3
4
Although the terms ‘consumer’ and ‘investor’ are sometimes used interchangeably in this
area, notably by the UK Financial Services Authority (FSA), the distinction can be meaningful: sect. III below and ch. 2.
It is not, accordingly, concerned with banking, insurance and pension-related services and
products although, as discussed throughout the book, investment product innovation has
placed considerable strains on the traditional regulatory segmentation between the banking,
insurance and investment sectors.
Ch. 2 considers ‘law in action’.
These include: FSA implementation of the behemoth Markets in Financial Instruments
Directive regime (Directive 2004/39/EC of the European Parliament and of the Council of
21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC
and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and
repealing Council Directive 93/22/EEC, OJ 2004 No. L145/1 (‘MiFID’)) and Commission
Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating
1
2
the retail investor and the ec
drawing on international experience and experience in the other Member
States.
Why consider the retail markets and retail market regulatory design?
As discussed in chapter 2, the financial crisis has wreaked destruction
on household market savings; it calls for careful consideration of the
role of regulation in the retail markets. But, before the financial crisis,
the retail markets were worthy of close attention. Greater responsibility for financial planning and welfare provision, including with respect
to pension provision,5 is being imposed on individuals and households
internationally;6 welfare is increasingly being privatized and governments
are seeking stronger individual financial independence. Risk is accordingly being transferred from government to households.7 Direct household participation in the markets8 is increasing;9 IOSCO, for example, has
5
6
7
8
9
conditions for investment firms and defined terms for the purposes of that Directive, OJ
2006 No. L241/26 (‘MiFID Level 2 Directive’) and the related extensive reforms to the FSA’s
retail market conduct-of-business regime, in particular (chs. 4 and 5); the FSA’s embrace
of a ‘more-principles-based’ regulation strategy (chs. 2 and 4); continuing efforts on the
pivotal ‘Key Features Document’ for retail investment products (ch. 5); burgeoning financial capability initiatives (ch. 7); ever-deepening research efforts (ch. 2); and radical and
far-reaching reform of the investment product distribution and advice regime under the
Retail Distribution Review (ch. 4).
E.g. S. Benartzi and R. Thaler, ‘Naive Diversification Strategies in Defined Contribution
Savings Plans’ (2001) 91 American Economic Review 79; and Ageing and Pension System
Reform: Implications for Financial Markets and Economic Policies (2005) (a report prepared at
the request of the Deputies of the G10 by an experts’ group chaired by I. Visco, Banca d’Italia)
(‘G10 Report’), identifying the importance of savings products which are complementary
to pension products and which provide diversification (pp. 15 and 17).
E.g. C. Borio, Change and Constancy in the Financial System: Implications for Financial
Distress and Policy (2007), ssrn abstractid=1022874 and European Commission, Minutes
of First Meeting of the Expert Group on Financial Education, 7 October 2008. The Dutch
financial market regulator (the AFM), for example, has highlighted that more responsibility
is being placed on citizens and noted the ‘democratization’ of financial options: AFM, Policy
and Priorities for the 2007–2009 Period (2007), pp. 11 and 12.
This point has been made in a range of studies. E.g. J. Delmas-Marsalet, Report on the
Marketing of Financial Products for the French Government (2005) (‘Delmas Report’) and
Subgroup (of the Council of the EU’s Financial Services Committee) on the Implications of
ageing on financial markets, Interim Report to the FSC (FSC4180/06, 2006) (‘FSC Report’).
The rise in defined benefit schemes, for example, has been described as turning employees
into investors and as underlining the importance of securities market regulation: M. Condon,
‘Rethinking Enforcement and Litigation in Ontario Securities Regulation’ (2006) 32 Queen’s
Law Journal 1, 6.
Other than the exposure to the markets which pension schemes and insurance products
achieve.
Particularly by older investors. ‘Baby boomers’ control more than US$13 trillion in household investable assets, or over 50 per cent of total US household investment assets: SEC,
the importance of the retail markets
3
highlighted increased levels of retail investor participation internationally
in collective investment schemes (CISs) and identified the securities markets as central to individual wealth. 10 And the financial markets have, as a
result, become significant politically.11
In the UK, the retail investment markets have become the focus of close
regulatory and policy attention. The FSA’s current attention to the effectiveness of investment advice ‘in action’ (chapter 4), for example, reflects
FSA concern to support effective investment advice and product distribution structures given government withdrawal from welfare provision,
changing spending and saving behaviour, shifting employment patterns
and other socio-economic factors which are placing pressure on longterm savings.12 Its annual Financial Risk Outlooks repeatedly highlight the
increased pressure being placed on individuals and households to become
financially independent and the risks which arise from failure to do so.
The 2005 Outlook, for example, identified increased longevity, health risks
(including obesity risks), increased individual responsibility for financing
education, changing patterns of employment (particularly an increase in
part-time and self-employed workers) and the need for long-term savings
in support of pension provision as significant trends that could (or should)
influence individuals’ financial planning; it also highlighted the risks of
over-reliance on property investments.13 In 2006, the FSA highlighted the
risks posed by individuals’ failures to address pension provision as well as
the stresses placed on financial planning by, amongst other factors, lifestyle
changes and child-care; similar concerns were highlighted in 2007.14 The
choices faced by individuals are also becoming increasingly complex as
governments encourage market participation and as the industry reacts.
Complex retail investment products are burgeoning,15 as are government
10
11
12
13
14
15
North American Securities Administrators Association and FINRA, Protecting Senior
Investors: Compliance, Supervisory and other Practices Used by Financial Services Firms
in Serving Senior Investors (2008) (‘SEC Senior Report’), p. 1. In the UK, three in eight families (with a member between the ages of 50 and 64) hold some form of investment, whether
directly or through some form of wrapper: FSA, Asset Ownership, Portfolios and Retirement
Saving Arrangements: Past Trends and Prospects for the Future (Consumer Research No. 74,
2008), p. 1.
IOSCO, Objectives and Principles of Securities Regulation (IOSCO, 2008), p. 1.
Zingales has suggested that the massive increase in the use of financial markets for retirement
purposes has made them much more important politically: L. Zingales, The Future of
Securities Regulation (2009), ssrn abstractid=1319648, p. 2.
FSA, A Review of Retail Distribution (Discussion Paper No. 07/1, 2007) (‘2007 RDR’), p. 17.
FSA, Financial Risk Outlook 2005, pp. 33–40 and 43.
FSA, Financial Risk Outlook 2006, pp. 71–4 and Financial Risk Outlook 2007, pp. 77–82.
See further ch. 3.
4
the retail investor and the ec
initiatives to encourage long-term and market-based savings; the UK Child
Trust Fund, for example, provides some limited exposure to the markets.16
The need for stronger financial independence, and for effective and
responsive retail markets, has been repeatedly highlighted by the Community institutions. Political direction has come from the Council of
the European Union, which has called on governments to strengthen the
tools with which they monitor household savings and to increase their
efforts to raise households’ awareness of financial education and information needs.17 The Council’s powerful Financial Services Committee has
engaged in a wide-ranging review of the implications of ageing populations
for financial markets, highlighting the macro-economic and demographic
trends which are leading to pressure on households to increase marketbased savings;18 while governments and financial institutions (such as
pension funds) have traditionally intermediated the risks of market investment, the Committee reported that they are now increasingly being carried
directly by households.19 The European Parliament, often sceptical of the
financial markets, has acknowledged that societal and lifestyle changes
demand sound management of private finances and has related better
financial literacy to lower levels of problem debt, increased savings and
adequate retirement provision.20 A similar concern has come from the
Community’s executive, the European Commission. In its 2007 Green
Paper on Retail Financial Services it argued that ageing populations and
increasing pressure on public finances presented ‘clear challenges for consumers and investors’ and highlighted the need for a ‘competitive, open
and effective market for long-term savings’.21 Earlier, its 2005 White Paper
on Financial Services called for a boost in the efficiency of pan-European
markets for long-term savings products.22 The need for regulatory policy to support long-term savings through the markets has also emerged
16
17
18
19
20
21
22
See further ch. 2.
ECOFIN Conclusions, 2798th Meeting, 8 May 2007, Press Release, pp. 10–11.
FSC Report. The dependency ratio (or the proportion of the population aged over 65 as a
proportion of the population aged 15–64) is expected to increase from 24 per cent in 2003
to 51 per cent in 2050 (p. 5) and substantial strain is accordingly expected on public pension
schemes (pp. 5–10). The Report suggested that higher levels of savings may be required
following changes to pension provision and to medical subsidies but that ‘investment in
riskier assets’ may reduce the need for additional savings (p. 11).
Ibid., pp. 14–16.
European Parliament, Resolution on Improving Consumer Education and Awareness on
Credit and Finance (P6–TA(2008)0539, 2008), paras. A and B.
European Commission, Green Paper on Retail Financial Services in the Single Market (COM
(2007) 226), p. 11.
European Commission, White Paper on Financial Services (2005–2010) (COM (2005) 629),
p. 4.
the retail markets and the ec
5
as a marked theme of the current debate on the treatment of substitute
investment products.23
Regulators internationally are also increasingly addressing the risks
faced by older and retired investors. The FSA has reviewed how the financial services market operates for older consumers and highlighted poor
understanding of retirement and associated products and services and
difficulties with access to advice;24 it has also underlined the particular
vulnerability of older investors to share scams.25 Internationally, the US
Securities and Exchange Commission (SEC) has also focused closely on the
protection of ‘senior investors’, adopting investor education programmes,
highlighting and prosecuting frauds and scams to which senior investors
may be vulnerable, and providing guidance to financial services firms.26
In this environment, the resilience of investor protection and the appropriateness of efforts to promote individual engagement with the markets
become of central importance.
II. The retail markets and the EC
1. The development of a retail market agenda
a) Early developments
In pursuit of the EC Treaty objective of securing an internal market
(Articles 3 and 14 EC) and in support of the Treaty free movement
guarantees,27 the Community institutions have long been engaged in
the construction of an integrated financial market within which market actors can freely access liberalized cross-border markets.28 Financial
market integration is presumed to generate significant benefits in terms
of choice, competition and easier access to capital and, ultimately, more
23
24
25
27
28
The Commission, for example, has acknowledged that the policy debate ‘assumes added
importance’ given the need to create the right conditions to support market-driven
solutions for private retirement provisioning: European Commission, Call for Evidence:
Need for a Coherent Approach to Product Transparency and Distribution Requirements for
‘Substitutive’ Retail Investment Products (2007), p. 21.
FSA, Finance in and at Retirement – Results of Our Review (2007). Although the FSA did
not find market failures, it highlighted difficulties concerning access to advice as well as
widespread poor understanding of retirement and associated products and services.
FSA, Press Release, 27 April 2009 (FSA/PN/055/2009). 26 SEC Senior Report.
Particularly the freedom to provide services (Art. 49 EC), the freedom to establish (Art. 43
EC) and the free movement of capital (Art. 56 EC). Treaty references are to the EC Treaty,
as the Treaty on the Functioning of the EU had not come into force at the time of writing
(see Preface and acknowledgments).
N. Moloney, EC Securities Regulation (2nd edn, Oxford: Oxford University Press, 2008),
ch. 1.
6
the retail investor and the ec
liquid and efficient markets and stronger economic growth.29 The legal
technology used to achieve market integration30 has been based on, first,
the liberalization of market access through de-regulation (or the removal
of Member States’ ability to impose local regulatory requirements on
cross-border actors) and, secondly, on the related re-regulation of those
markets by a common harmonized rule base. Liberalization is achieved
by the requirement for Member States to accept, or mutually recognize,
the regulation (and often supervision) of cross-border actors by those
actors’ home Member States (typically the State where the actor has its
head office); mutual recognition is supported by re-regulation or the harmonization of Member States’ rules in order to remove the integration
obstacles which protectionist or, more usually, diverging local rules represent, and to allow mutual trust between regulatory regimes. As part of this
process of de-regulation, liberalization and re-regulation, the regulation
of domestic financial markets has, over time, moved from the Member
States to the EC and become a function of harmonized rules. But the
Community’s embrace of retail investor protection regulation and policy
is a relatively recent phenomenon.
The seminal 1966 Segr´e Report, the opening salvo in what has since
become a massive harmonized regulatory programme for financial services and markets, did not address retail investor protection in any detail.31
The early phases of EC financial market regulation (from the late 1970s)
were concerned with supply-side market access. Integration was initially
sought through, first, detailed rule harmonization (best exemplified by the
early securities directives (now repealed) which addressed capital-raising,
disclosure and issuer access to cross-border markets) and, secondly, in
the wake of the 1985 Commission White Paper on the Internal Market,32
minimum harmonization (which allowed Member States to impose more
stringent rules on their domestic actors and so accommodated some degree
29
30
31
32
E.g. London Economics, Quantification of the Macro-Economic Impact of Integration of EU
Financial Markets: Final Report to the European Commission (2002).
Whether or not law can drive market integration and change actors’ behaviour is a very
large question. On the debate, see further Moloney, EC Securities Regulation, pp. 40–7 and,
in the retail context, sect. II.3 below and ch. 2.
Perhaps because at that time ‘in continental Europe stockbrokers and other dealers are not
organized in such a way as to facilitate contacts with the public at large. As for investment
consultants, they are still far removed from the developed stage they have attained on the
capital markets of some non-member countries’: Report by a Group of Experts Appointed
by the EEC Commission, The Development of a European Capital Market (1966) (‘Segr´e
Report’), p. 204.
European Commission, Completing the Internal Market (COM (85) 310).
the retail markets and the ec
7
of regulatory competition) and mutual recognition (best exemplified by
the 1985 UCITS Directive33 on the UCITS CIS and the now-repealed
1993 Investment Services Directive (ISD) on investment services34 ). The
ISD asserted in a recital reference that one of its objectives was to protect
investors. But this assertion sat very uneasily in a Directive which was primarily focused on the investment firm, on the investment services passport
and on achieving the minimum level of harmonization required to support
home Member State control of cross-border investment firm activity. ISD
harmonization was primarily directed to prudential and stability requirements; marketing and conduct-of-business regulation, touchstones for
investor protection in the intermediation context, were not harmonized
and were thus left to the control of host Member States.
The first significant moves towards a harmonized investor protection
regime came in the late 1990s when market integration became more
closely associated with the demand-side, the support of investor confidence as a means of encouraging integration35 and, accordingly, the
harmonization of investor protection rules. The first hint of an investorfacing approach came in 1996 when the Commission presented its Green
Paper on Financial Services Consumers36 which highlighted a number of
investor protection concerns including aggressive marketing by investment firms and poor disclosure. A separate development outside the
financial market policy sphere, the adoption of the 2000 E-Commerce
Directive,37 further sharpened the focus on investor protection. The Directive anchored cross-border e-commerce/online services (including online
investment services) to the ‘Member State of origin’ (essentially the State
of establishment) and removed the ability of host Member States to apply
their protective rules to cross-border online services. The Directive’s striking innovation was to remove host State control without parallel rule
harmonization. By such accidents, or at least by a lack of joined-up
33
34
35
36
37
Council Directive 85/611/EEC of 20 December 1985 on the co-ordination of laws, regulations and administration provisions relating to undertakings for collective investment in
transferable securities, OJ 1985 No. L375/3.
Council Directive 93/22/EEC of 10 May 1993 on investment services in the securities field,
OJ 1993 No. L141/27.
N. Moloney, ‘Confidence and Competence: The Conundrum of EC Capital Markets Law’
(2004) 4 Journal of Corporate Law Studies 1.
European Commission, Green Paper on Financial Services: Meeting Consumers’ Expectations
(COM (96) 209).
European Parliament and Council Directive 2000/31/EC of 8 June 2000 on certain legal
aspects of information society services, in particular electronic commerce, in the single
market, OJ 2000 No. L178/1.
8
the retail investor and the ec
thinking across different Commission divisions, do major shifts in regulatory design occur. The subsequent 2001 Communication on E-Commerce
and Financial Services38 called for further convergence of protective rules,
including conduct-of-business rules, in order to address the danger that
Member States would rely on the E-Commerce Directive’s derogations to
the Member-State-of-origin principle to protect investors and consumers
where the Member State of origin’s rules were not regarded as offering
adequate protection. But the Communication also adopted an investorfacing agenda. It linked market integration to the demand side and noted
that ‘consumer confidence’ depended on sufficiently harmonized levels
of protection. An initial response came in the form of the 2002 Distance
Marketing of Financial Services Directive (DMD),39 which addresses disclosure, marketing, contractual rights (including withdrawal rights) and
redress in the distance marketing context and which applies to a range
of financial services, including investment services. It was the EC’s first
sustained attempt to grapple with investor protection. It also reinforced
the emerging reliance on ‘confidence’ as a demand-side justification for
harmonization and market-integration measures; it argued that a high
degree of consumer protection was required to enhance consumer confidence in distance selling (recital 3), and that a high level of consumer
protection should be guaranteed by the Directive (recital 13).
b) The FSAP and the retail interest
Before the pivotal 1999 Financial Services Action Plan (FSAP),40 a massive regulatory agenda which was designed to complete the integration
of financial markets and remedy years of slow development, had begun
to gather steam, the establishment of the Lamfalussy structures for EC
law-making in the financial market sphere brought another influence to
bear on the developing retail market agenda. The seminal 2001 Lamfalussy
Report41 was concerned with the establishment of a new EC law-making
mechanism for delegated law-making (which empowers the Commission
38
39
40
41
European Commission, Communication on E-Commerce and Financial Services (COM
(2001) 66).
European Parliament and Council Directive 2002/65/EC of 23 September 2002 concerning the distance marketing of consumer financial services and amending Council Directive 90/619/EEC and Directives 97/7/EC and 98/27/EC, OJ 2002 No. L271/16 (‘Distance
Marketing Directive’ or DMD).
European Commission, Communication on Implementing the Framework for Financial
Markets: Action Plan (COM (1999) 232) (FSAP).
Final Report of the Committee of Wise Men on the Regulation of European Securities Markets
(2001) (‘Lamfalussy Report’).
the retail markets and the ec
9
to adopt delegated rules, advised by the Committee of European Securities
Regulators (CESR, composed of Member State regulators) and supervised
by the European Securities Committee (ESC, composed of Member State
representatives)).42 Financial market rules now take the form of ‘level 1’
measures (typically directives) adopted by the institutions under traditional Treaty law-making procedures, detailed ‘level 2’ rules adopted by
the Commission and ‘level 3’ guidance adopted by CESR.43 But the Lamfalussy Report also prioritized retail investor protection. It highlighted
the absence of ‘high and equivalent levels of consumer protection and
no efficient methods for resolving cross-border consumer disputes’ and
recommended that ‘the conceptual framework of overarching principles’,
on which, it suggested, all EC financial market regulation should be based,
include a commitment to ensuring ‘appropriate levels of consumer protection proportionate to the different degrees of risk involved’.44 Its lasting
legacy to the retail market agenda, however, was the establishment of CESR,
which has had a far-reaching influence on the EC retail market agenda.45
The explosive combination of the Lamfalussy law-making reforms and
the FSAP regulatory reform agenda led to an exponential increase in
the intensity of EC financial market regulation over the FSAP period
(1999–2004). The FSAP also included a discrete retail market agenda46 and
the retail market interest emerged strongly across a series of FSAP measures. The first indications of the adoption of a retail market agenda came
with the 2003 Prospectus Directive.47 While designed to support crossborder capital-raising by issuers (by harmonizing prospectus requirements
and clarifying the scope of private placements), it is also designed to
build the confidence of ‘small investors’ in financial markets (recital 41)
and has a strong retail orientation;48 recital 16 states that ‘one of the
objectives of this Directive is to protect investors’.49 The most dramatic
42
44
46
47
48
49
See further ch. 7. 43 Ibid.
Lamfalussy Report, pp. 12 and 22. 45 See further ch. 7.
‘Appropriate and progressive harmonization of marketing and information rules throughout the Union together with a pragmatic search for non-legislative solutions offers the
prospect of a truly integrated retail market fully respecting the interests of consumers and
suppliers’: FSAP, p. 10.
Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003
on the prospectus to be published when securities are offered to the public or admitted to
trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64 (‘Prospectus Directive’).
The European Commission’s advisory European Securities Market Expert Group has
described the principal objective of the Prospectus Directive as to protect the retail investor:
ESME, Report on Directive 2003/71 (2007), p. 10. See further ch. 6.
But investor protection runs across the Directive. E.g. recitals 10, 18, 19, 20 and 21.
10
the retail investor and the ec
developments, however, occurred with MiFID.50 The massive MiFID
regime, discussed throughout this book, is expressly designed to support
investor protection (e.g. recital 31)51 and addresses conduct-of-business
regulation (including marketing, disclosure and suitability requirements),
best execution, conflict-of-interest management and order execution and
market transparency. MiFID is also notable for the Commission’s related
regulatory rhetoric which claims investor protection (domestically and
cross-border) as a legitimate concern of EC financial market regulation52
and which appears to break the link between investor-protection-based
harmonization and market integration;53 under MiFID, investor protection has become an end in itself. The MiFID Proposal was designed to
address the failure of the precursor ISD to provide a ‘bedrock of harmonized investor protection’,54 while the pivotal conduct-of-business regime
was described as a ‘mainstay of investor protection’.55 In one of the more
striking of MiFID’s many retail market innovations, the regulation of
investment advice has now become a function of EC law (chapter 4). But
50
51
52
53
54
It has been described as ‘the most significant directive in capital markets law of recent
times’: BaFIN, Annual Report 2007–2008, p. 12.
The FSA has described MiFID in investor protection terms: ‘One of the main objectives
of MiFID is to provide a high level of investor protection’: Reforming Conduct of Business
Regulation (Consultation Paper No. 06/19, 2006), p. 9.
‘There is a need for enlightened regulation to define the rules of the game and for strong
policemen to enforce these rules . . . [MiFID] should equip regulators with a comprehensive
set of regulatory disciplines to tackle the risks to which the modern retail investor is
exposed . . . A high level of protection is crucial in its own right [emphasis added]. It is
also a pre-condition for the effective operation of the ISD passport’: Speech by DirectorGeneral Schaub of the Internal Market Directorate General on ‘Economic and Regulatory
Background to the Commission Proposal for Revision of the ISD’, 15 October 2002, available
via http://europa.eu/rapid/searchAction.do.
All EC legislative measures must meet subsidiarity and proportionality requirements and be
based on a Treaty competence (Art. 5 EC). In the financial markets sphere, harmonization
has typically been based in the free-movement- and barrier-removal-related competences
set out in Art. 44(2)(g) EC (directives designed to co-ordinate the safeguards required by
Member States of companies or firms for the protection of members and others), Art.
47(2) EC and Art. 55 EC (directives designed to co-ordinate Member States’ rules on the
taking up and pursuit of activities as self-employed persons) and in the two general single
market competences, Art. 94 EC (directives for the approximation of Member States’ rules
which directly affect the establishment or functioning of the common market) and Art. 95
EC (measures for the approximation of Member States’ rules which have as their object
the establishment and functioning of the internal market). The EC institutions do not
enjoy a general power to regulate the internal market. Internal market measures must be
based on the need to remove regulatory barriers or distortions to competition, although
the Commission has rarely appeared troubled by this restriction: Moloney, ‘Confidence
and Competence’.
European Commission, MiFID Proposal (COM (2002) 625), p. 23. 55 Ibid., p. 25.
the retail markets and the ec
11
investor protection, not market integration, is the concern; recital 3 does
not justify the inclusion of advice by reference to the integration of the
advice industry. It notes instead that ‘due to the increasing dependence
of investors on personal recommendations’ it was appropriate to include
investment advice as a service requiring authorization. On its application
on the markets in November 2007 the Commission greeted MiFID as a
robust and comprehensive framework for ensuring high levels of investor
protection.56 The investor protection rhetoric has also been taken up by
CESR which described the harmonization of ‘investor protection throughout Europe and increase[ing] consumers’ confidence that the products
they are being sold are actually appropriate for their needs’ as ‘one of the
main purposes’ of MiFID.57
c) Post-FSAP
Post-FSAP, the policy focus on the retail markets has continued. Integration has often been a subsidiary concern in this period which has
seen a focus on effective regulatory design for the retail markets. In the
UCITS investment products sphere,58 for example, radical reforms to
the design of UCITS disclosure are taking place; the EC is also grappling with the difficulties raised by substitute investment products and
the retailization of alternative investments.59 This period is also strongly
associated with a more holistic appreciation of retail market policy and
with a concern to promote financial literacy, stronger retail involvement
in the law-making process and access to redress.60 Belated efforts are also
being made to understand retail investor behaviour, with the publication
of important reports on long-term retail saving patterns61 and on retail
market disclosures.62
The Commission’s 2007 Green Paper on Retail Financial Services63
points to the entrenchment of the retail market agenda. Its earlier 2005
56
57
58
59
61
62
63
European Commission, Press Release, IP/07/1625.
Press Release Accompanying the Retail Investor Guide to MiFID (CESR/08-209, 2008),
p. 1.
The EC’s collective investment regime focuses on the UCITS product.
Chs. 3 and 5. 60 Chs. 7 and 8.
BME Consulting, The EU Market for Consumer Long-Term Retail Savings Vehicles: Comparative Analysis of Products, Market Structure, Costs, Distribution Systems, and Consumer
Savings Patterns (2007) (‘BME Report’).
Optem, Pre-contractual Information for Financial Services: Qualitative Study in the 27 Member States (2008) (‘Optem Report’).
European Commission, Green Paper on Retail Financial Services.
12
the retail investor and the ec
White Paper on Financial Services Policy had identified the retail market
as a key element of the 2005–10 financial services agenda and committed
to a series of investor-facing initiatives, including with respect to investor
education initiatives, investor governance and redress.64 The 2007 Green
Paper was concerned with ensuring that the integrated financial services
market (including investment services) delivered products that met consumer needs, enhancing consumer confidence by ensuring consumers
were properly protected and empowering consumers to take the right
decisions.65 Retail financial services markets (including investment services) were also a theme of the Commission’s wider 2007 internal market
policy initiative which addressed the distribution of investment products,
financial education and redress.66 By late 2007, the retail interest in financial services generally had become a major policy priority.67 The shift
in emphasis is well illustrated by the minutes of the Commission’s then
newly constituted consultative Financial Services Consumer Group which,
in December 2007, noted that transparency, the provision of information
and education were all key elements of the current policy debate.68 None
of these elements was a feature of the EC policy debate prior to the FSAP.
Why did retail investor protection acquire such prominence, particularly given the absence of retail stakeholders from the policy debate
(chapter 7)? Traditional integration concerns are certainly a factor, as
is the internal momentum which the FSAP and the Lamfalussy model
generated.69 But regulatory empire-building by the Commission, the
engine of policy development in the EC, cannot be discounted given
the political power of the retail market agenda and its association with
regulation. Member States have become increasingly willing to devolve
retail market regulation to the EC (section II.2.c below). And, perhaps
above all, the Commission has embraced the investor empowerment and
‘marketing the markets’ agenda which is becoming associated with retail
investor policy internationally (chapter 2).
64
65
66
67
68
69
European Commission, White Paper on Financial Services, pp. 7–8.
European Commission, Green Paper on Retail Financial Services, pp. 2–3.
European Commission, A Single Market for 21st Century Europe (COM (2007) 725), Staff
Working Paper on Initiatives in the Area of Retail Financial Services.
The Commission argued that ‘consumer information and protection are at the heart of EU
financial services legislation’: European Commission, Communication from the Commission, Financial Education (2007), p. 1.
Financial Services Consumer Group, Minutes, 12 December 2007.
See further Moloney, EC Securities Regulation, pp. 19–22.
the retail markets and the ec
13
2. Scope: the reach of EC investor protection law and policy
a) Main elements
The main concerns of investor protection regulation – investment
product regulation, disclosure, distribution and advice and trading
rules70 – are now all governed by the harmonized EC regime, albeit to
varying degrees; the scope of the investor protection regime has been further extended by CESR’s quasi-law-making activities.71 The EC regime is
not limited to cross-border activity but applies to local activity. The UCITS
regime, for example, applies to all UCITS schemes, whether or not they
avail themselves of the Directive’s passporting opportunities (Article 1).
MiFID similarly applies to all investment firms within its scope, whether
or not they engage in cross-border activity (Articles 1 and 5).
Investment product regulation (chapter 3) is addressed by the UCITS
regime. Disclosure (chapter 5) forms a large component of the retail market regime and is governed by the UCITS regime (UCITS disclosure), the
Prospectus and Transparency72 Directives (issuer disclosure) and MiFID
and the DMD (disclosure related to product distribution and to investment services). The distribution of investment products and investment
advice (chapter 4) is addressed by MiFID and the DMD; a limited regime
applies to the distribution of investment-related unit-linked insurance
products under the Insurance Mediation Directive.73 MiFID also addresses
the trading process. Retail investors additionally benefit from a range of
contractual and marketing protections under the harmonized consumer
protection regime, notably the 1993 Unfair Contract Terms Directive74
and the 2005 Unfair Commercial Practices Directive.75
Despite its reach, the EC’s investor protection regime is, as discussed
in subsequent chapters, segmented and does not always capture the reality of mass market investment. MiFID, for example, does not cover the
70
72
73
74
75
Ch. 2 considers the main tools for intervening in the retail markets. 71 Ch. 7.
Directive 2004/109/EC of the European Parliament and of the Council of 15 December
2004 on the harmonisation of transparency requirements in relation to information about
issuers whose securities are admitted to trading on a regulated market and amending
Directive 2000/34/EC, OJ 2004 No. L390/38 (‘Transparency Directive’).
European Parliament and Council Directive 2002/92/EC of 9 December 2002 on insurance
mediation, OJ 2003 No. L9/3.
Council Directive 93/13/EEC of 5 April 1993 on unfair terms in consumer contracts,
OJ 1993 No. L95/29.
Directive 2005/29/EC of the European Parliament and of the Council of 11 May 2005
concerning unfair business-to-consumer commercial practices in the internal market,
OJ 2005 No. L149/22 (‘Unfair Commercial Practices Directive’).
14
the retail investor and the ec
distribution of unit-linked insurance-related investments or structured
retail products with deposit elements,76 both of which are popular retail
market investments but both of which are vulnerable to regulatory arbitrage risks with respect to distribution requirements and product design
and disclosure rules.
b) A prescriptive regime
The harmonized retail markets regime has become highly prescriptive.
This is in part related to the Lamfalussy model and to the adoption of
detailed level 2 rules77 and the accretion of CESR guidance at level 3;
the crisis, and related EC institutional reforms, will also likely lead to
an increase in the volume of technical rules (chapter 7). But it is also a
function of the extent to which a maximum harmonization model, which
ousts Member States’ ability to apply additional rules in the harmonized
area to domestic actors,78 has been adopted for retail market rules.
The DMD contained an augury of what was to come by employing a
maximum harmonization model and removing Member State ability to
apply additional local rules to domestic actors.79 Recital 13 of the Directive provides that Member States should not be able to adopt provisions
other than those laid down by the Directive in the field it harmonizes.
The prospectus regime, while not formally a maximum harmonization
regime, severely limits, given the scale of the harmonization, the extent to
which Member States can use the prospectus regime to address local retail
markets risks, including with respect to the offering of retail structured
products, a current preoccupation of retail market policy (chapter 3).
In the consumer protection field, the Unfair Commercial Practices Directive adopts a maximum harmonization model, although financial services,
given their complexity and the risks to consumers (recital 9), are subject
to a specific derogation which permits super-equivalent rules (Article
3(9)). The consumer protection field has also seen some enthusiasm for
consumer protection directives (including the Unfair Contract Terms
Directive) to be recast as maximum harmonization measures.80
76
78
79
80
See further ch. 4. 77 Notably the MiFID Level 2 Directive.
Applying additional rules to passporting actors would be in breach of the relevant directives
as well as, potentially, the Treaty free movement guarantees.
Member States are, pending further harmonization, allowed to impose more stringent
disclosure requirements to those imposed on distance marketing by the Directive (Art.
4(2)). MiFID, however, means that Member States have very limited discretion with respect
to investment services disclosure.
The Commission’s review of the consumer acquis highlighted the fragmentation risks
consequent on minimum harmonization measures and canvassed whether a horizontal,
the retail markets and the ec
15
But the MiFID Level 2 Directive, which is pivotal to the regulation of
product distribution and advice as well as to trading regulation, provides
in Article 4 the clearest example of the extent to which Member States’ regulatory discretion over the retail markets has been restricted. Article 4(1)
addresses ‘gold-plating’ (or the imposition of local super-equivalent rules,
additional to directive requirements, on domestic actors) and severely
limits the extent to which Member States can impose additional obligations on local markets and actors. Member States may only do so in
‘exceptional cases’ where the rules in question are objectively justified and
proportionate so as to address specific risks to investor protection or to
market integrity which are not adequately addressed by the Directive.81
The additional rules must also either address a specific risk of particular
importance given the Member State’s market structure or address risks or
issues that emerge or become evident after the coming into force of MiFID
and are not otherwise regulated by the Community. This ‘gold-plating’
ban represents a political consensus during the MiFID level 1 negotiations that uniform solutions be adopted.82 As discussed in chapter 2,
harmonization of this intensity and the ousting of Member State discretion in purely local markets potentially poses considerable risks to investor
protection given the heterogeneous nature of the Community retail
market.
The extent of the EC’s influence is well illustrated by its impact on
the UK regime ‘on the books’. The FSA has acknowledged that its rules
are now based on EC requirements,83 that implementation of the MiFID
conduct-of-business regime would ‘over-write’ many of the pre-existing
81
82
83
maximum harmonization measure should be adopted and/or earlier measures tightened:
European Commission, Green Paper on Review of the Consumer Acquis (COM (2006)
744). Industry stakeholders were supportive of more extensive harmonization although
consumer stakeholders were more sceptical: European Commission, Report on the Outcome
of the Public Consultation on the Green Paper on the Review of the Consumer Acquis (2007).
The Commission has now proceeded with a proposal for an omnibus directive on consumer
rights (COM (2008) 614) which updates and strengthens earlier measures (including the
Unfair Contract Terms Directive) and adopts a maximum harmonization model.
Applications have not been common. As at September 2009, only France, Ireland and the
UK had made Art. 4 applications: European Commission, MiFID Transposition State of
Play Table. Ch. 4 considers the UK experience.
The Art. 19(10) level 2 delegation for conduct-of-business rules, for example, refers to the
‘uniform application’ of Art. 19, as does the Art. 18(3) delegation for conflict-of-interest
management. ‘Uniform application’ is also a concern of the best-execution delegation
(Art. 21(6)) and the order-handling delegation (Art. 22(3)).
E.g. ‘For the most part, our rules reflect the standards set out in Directives’: FSA, Consumer
Responsibility (Discussion Paper No. 08/5, 2008), p. 25.
16
the retail investor and the ec
FSA conduct-of-business requirements84 and that its Conduct of Business
sourcebook (COBS), central to investor protection in the UK retail market,
is now governed by the requirements of MiFID, the Insurance Mediation
Directive and other EC measures and that these requirement are often, in
a form of quasi-harmonization, applied by the FSA to local activities and
instruments outside the scope of these measures.85 The Retail Distribution
Review, central to the UK’s current efforts in the retail market, has also
highlighted that EC measures, as well as the Commission’s overall policy
direction with respect to retail financial services, have the potential to
influence how the UK distribution and advice market works.86
c) The movement of retail market issues from the Member
States to the EC
The reach of the EC over local and cross-border retail markets is also clear
from the growing tendency of the Member States, notwithstanding the sensitivities of local retail markets, to view retail market policy and reaction
to new developments in terms of a co-ordinated Community response.
The highly sensitive question of retail investor access to alternative investments, for example, saw the FSA acknowledge the need to co-ordinate with
the Community.87 Although regulators have been struggling domestically
with how to design effective investment product disclosure, there appears
to have been little resistance to the current UCITS ‘Key Investor Information’ (KII) reform, although it removes Member State discretion in this
area (chapter 5). The current debate on substitute investment products
(chapter 3) has also seen support for a co-ordinated response.88
The industry also appears conscious of the likelihood but also the
potential value of EC intervention. The FSA’s massive Retail Distribution
Review generated some resistance to the FSA’s reforms given the risk that
84
85
86
87
88
Consultation Paper No. 06/19, p. 7.
FSA, Response to the European Commission’s Call for Evidence on Need for a Coherent
Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail
Investment Products (2008) (‘FSA Substitute Products Response’), p. 2.
2007 RDR, p. 5.
FSA, Wider Range Retail Investment Products (Discussion Paper No. 05/3, 2005), noting
that ‘any enduring solution will need to take account of, and preferably influence, the
developing European and international debate’ (p. 7).
European Commission, Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Investment Products: Feedback Statement on
Contributions to the Call for Evidence (2008), pp. 29–30 and 35. The Retail Distribution
Review reforms have been extended to reflect the scope of the Commission’s proposals:
FSA, Distribution of Retail Investments: Delivering the RDR (Consultation Paper No. 09118,
2009), p. 11.
the retail markets and the ec
17
the FSA’s radical plans might be overtaken by EC developments.89 In a
notable example of the industry using EC influence on domestic policy,
the substitute product debate saw two leading UK trade associations raise
their concerns with respect to the local regulatory treatment of a domestic
product before the Commission.90 The recent concern in the UK to address
the risks posed by ‘boiler rooms’91 has also seen a leading trade association
call for co-ordinated action between the UK, the Commission and national
regulators.92
MiFID, in particular, marked a greater willingness to address retail
market regulatory issues centrally and through maximum harmonization measures. The earlier Council negotiations on the DMD were difficult and focused in particular on the Directive’s ‘abandonment of
the minimum harmonization principle’93 and the extent to which local
consumer-protection (particularly disclosure) regimes could be accommodated within the Directive’s maximum harmonization structure. The
MiFID level 2 negotiations, however, appear to have been more concerned
with preventing gold-plating than with addressing the retail market risks
generated by a removal of Member State flexibility. There is also evidence
of Member State reliance on MiFID as a template for wider national retail
market reforms;94 the European Court has confirmed the intuition that
Member States can expand the scope of EC measures domestically as
long as the national measure makes clear that it does not implement a
Community rule.95
89
90
91
93
94
95
The Association of Private Client Investment Managers (APCIMS) warned that the FSA’s
determination to lead the way might result in their wasting time and resources on domestic regulatory initiatives which were subsequently taken over by European requirements:
APCIMS, Response to DP 07/1 (2007), p. 1.
The Investment Management Association (IMA) raised its concern (which it had already
expressed domestically) as to the UK regulatory treatment of the Global Equity Bond
(issued by the UK’s National Savings and Investments body, which is backed by HM
Treasury) which is not subject to the full application of the FSA’s disclosure and marketing
regime. The IMA argued that it was inappropriately marketed as a substitute product for
equity market investments although, based on the IMA’s research, it under-performs the
market and is not a safe substitute for stock investments: (IMA), Response to Commission
Call for Evidence on Substitute Products (2008), pp. 1–2 and Annex.
See further ch. 4. 92 APCIMS, Press Release, 14 May 2008.
European Commission, Report on the Common Position (SEC (2002) 30), p. 3.
Portugal, for example, has applied MiFID-style disclosure and suitability obligations to the
sale of insurance and pension products (which are outside the scope of MiFID): Comiss˜ao
do Mercado de Valores Mobili´arios (CMVM) Regulation No. 8/2007. See n. 139 below on
the FSA position.
Testa and Lazzeri [2002] ECR I-10797 (Case C-356/00).
18
the retail investor and the ec
It may be that CESR’s burgeoning influence on policy development,
the opportunities it provides for strengthening trust between regulators
and its recent adoption of a retail market agenda have contributed to a
greater degree of comfort with EC initiatives.96 It may also be that the
recent enhancement to the policy and regulatory design process under
the Lamfalussy process and the Better Regulation agenda,97 including
more extensive consultation procedures, better cost/benefit analysis and
the recent striking attempts to locate policy developments in a better
understanding of the nature of the retail market,98 are leading Member
States to give more weight to the economy of scale benefits of EC intervention than to the restrictions posed by harmonized rules. Given that retail
market measures are often associated with higher industry costs, the EC
may also provide useful political cover for Member States seeking retail
market reforms to emerging risks. Although retail investors do not yet act
as a coherent group in policy-making, intriguing evidence has emerged
of investors’ regarding the Commission as their champion against the
financial services industry; this enthusiasm for EC action extends to those
traditionally more eurosceptic Member States, such as the UK.99 Member
States may therefore find it more palatable to adopt EC-driven solutions
to emerging problems.
3. Beyond the cross-border context
While the harmonized retail market regime applies to local as well as crossborder activity, the regime’s roots are in the construction of an internal
market. But the construction of the retail integrated market has proved
to be highly troublesome; integration is proceeding very slowly, and the
impact of harmonization has not been significant. But this has not affected
96
97
98
99
Ch. 7 considers CESR.
Which the Commission committed itself to follow in the financial services sphere: White
Paper on Financial Services Policy, pp. 4–8. See generally R. Haythornthwaite, ‘Better Regulation in Europe’ in S. Weatherill (ed.), Better Regulation (Oxford and Portland, OR: Hart
Publishing, 2007), p. 19.
See further chs. 2 and 7.
Optem Report, p. 16. The Report found that ‘in a number of countries (Eastern European
Member States, Italy, Ireland and the UK), the Commission was seen as the institution
that was most capable of regulating a sector that has been dogged by scandal’ (p. 117).
Comments included ‘I think it’s great that they [the EC] are trying to do something to help
the consumer’ (from the UK) and ‘It’s very positive that the [Commission] pays attention
to a sector of the financial market where – at least in Italy – so many frauds have damaged
thousands of honest citizens who were simply looking to protect their life’s savings’ (from
Italy) (p. 117).
the retail markets and the ec
19
the reach of the regulatory regime into local markets or the ambition of the
EC’s regulatory strategy for the retail markets, underlining the regulatory
quality of the harmonized regime.
Poor levels of cross-border activity in retail financial services generally were reported in the Commission’s first (2004) Financial Integration
Monitor;100 direct cross-border offers of retail financial products were the
exception and product delivery to the end-investor was typically through
local distribution networks.101 In 2005, there was little change: ‘the degree
of fragmentation in retail markets is still considerable’.102 The 2006 Monitor focused on the CIS sector and reported significant differences in
investors’ preferences for cross-border schemes.103 Since then, MiFID has
come into force, but progress has remained very slow. The 2007 review
reported continuing fragmentation in the retail markets,104 as did the
2008 review which found that a single retail financial market was ‘far
from being achieved’.105 Cross-border transactions by individuals were
limited and prices, products and distribution channels all varied across
local markets. To the extent integration was taking place, it was on the supply side and through firms, particularly retail banks (which typically take
the form of multi-service ‘financial supermarkets’ in continental Europe),
establishing cross-border subsidiaries and branches,106 reflecting strong
demand-side preference for local suppliers.107
100
101
102
103
104
105
106
107
European Commission, Financial Integration Monitor 2004 (SEC (2004) 559).
Ibid., pp. 5 and 17.
European Commission, Financial Integration Monitor 2005 (SEC (2005) 927)
(‘2005 Monitor’), p. 12. It reported that only 5 per cent of EU citizens had bought a
financial product from another Member State (and these purchases were usually related
to migration) (p. 10).
European Commission, Financial Integration Monitor 2006 (SEC (2006) 1057) (‘2006
Monitor’), pp. 21–2.
European Commission, European Financial Integration Report 2007 (SEC (2007) 1696)
(‘2007 Monitor’), pp. 13 and 17.
European Commission, European Financial Integration Report 2008 (SEC (2009) 19) (‘2008
Monitor’), p. 14.
Ibid., pp. 10 and 14. The 2007 Monitor reported an increasing number of cross-border bank
branches, although subsidiaries were the dominant form of cross-border establishment
with their assets amounting to 10.5 per cent of the EU-25 market as compared to an 8.5
per cent share by branches (p. 15).
The 2005 Monitor noted that consumers do not appear to distinguish between foreign
and domestic providers where they are both established locally (p. 10), while the 2006
Monitor also emphasized local establishment (p. 5). The 2003 preparatory Monitor had
previously highlighted the importance of proximity in the retail markets: Tracking EU
Financial Integration (2003) (SEC (2003) 628), p. 5.
20
the retail investor and the ec
Close attention was given to cross-border activity in the important 2007
BME Report on long-term savings in the EC. It found that retail consumers
were participating in the integration process indirectly through CISs which
invested in cross-border assets, but that the market in long-term savings
products was highly fragmented.108 It reported modest levels of crossborder activity, wide variations in prices, restricted product diversity and
choice, variations in the performance of intermediaries109 and a strong
preference for local providers.110 It also reported on the extensive evidence of national segmentation in the distribution of investment products
and the delivery of investment advice (chapters 3 and 4).111 Reluctance to
engage with cross-border services and products is also clear from the Commission’s Eurobarometer surveys of public opinion. In 2005, it reported
high levels of reluctance to obtain cross-border financial services and that
85 per cent of respondents had not purchased financial services from firms
situated in other Member States.112
An integrated retail investment services market could offer retail
investors significant benefits in terms of product and services competition, wider choice, cost discipline and better diversification – although
this assumption makes significant demands on the retail investor’s ability
to exercise choice effectively.113 But whether or not a cross-border market can be driven by regulation is highly doubtful. Cross-border activity
in the retail markets, on the demand side,114 depends on a range of factors, few of which are amenable to regulation. Language difficulties are
a significant inhibitor. So too is the tendency of retail investors to prefer local suppliers and to exhibit a strong home bias in investments.115
Cultural factors can affect the extent to which investors operate
108
112
113
114
115
BME Report, p. 11. 109 Ibid., p. 26. 110 Ibid., p. 15. 111 Ibid., pp. 100–47.
European Commission, Special Eurobarometer No. 230, Public Opinion in Europe on Financial Services (2005), p. 10. Enthusiasm for future cross-border purchases varied, however.
87 per cent of Greek respondents would not purchase cross-border in future but respondents in France, Ireland, Malta and Slovakia were more open to cross-border purchases
(p. 11). Consumers in the new Member States, however, appear more open to crossborder financial services, suggesting some lack of trust in domestic institutions: European
Commission, Eurobarometer 2003:5 (published in 2004) Financial Services and Consumer
Protection: Summary Report (2004), p. 4.
Discussed further in chs. 2, 3 and 5.
The supply side will have limited incentives to engage without investor demand. The
supply side also faces other obstacles including with respect to diverging non-harmonized
rules, litigation and supervisory risks, taxation, personnel, payment/credit assessment
and other infrastructure difficulties and the need to adapt products, business models and
pricing strategies: European Commission, Green Paper on Retail Financial Services, p. 6.
See further ch. 2.
the retail markets and the ec
21
cross-border.116 Market infrastructure can cause difficulties;117 fragmentation in clearing and settlement increases the cost of retail trading.118 Taxation remains a significant obstacle. Although the BME Report suggested
that investment (and banking) products had greater potential for integration than pension and insurance products, it highlighted a wide range of
obstacles, including wide variations in investment behaviour (section III
below), a home bias and preference for familiar products and services,
information failures, language difficulties, national product segmentation
(including the local distribution of government bonds), higher fees for
cross-border investments, higher investment thresholds for cross-border
investments, switching penalties, lack of transparency and diverging welfare systems which generate different incentives to purchase investment
products.119 The fate of the DMD provides a vivid example of the limitations of law. Two extensive 2008 studies on the Directive’s impact on the
construction of a cross-border market in distance financial services point
to a signal failure. One found that there was no significant cross-border
activity in the distance marketing of financial services and that the failure
of the market to develop was linked not to legal difficulties but to language,
cultural factors and the nature of financial services.120 The second reported
that there was no meaningful cross-border provision of distance marketing of financial services either before or after the Directive, which had little
or no impact. It highlighted the difficulties caused by taxation, electronic
contracts, cultural and language difficulties and consumer preferences for
local providers.121
There now appears to be a policy realization that harmonization is a
limited tool for driving cross-border activity in the retail sector. The Commission’s 2007 Green Paper on retail financial services acknowledged that
integration had not reached its potential with only modest cross-border
activity, wide variations in price, restricted product diversity and choice
and large variations in the profitability of retail providers.122 Stakeholders
are also doubtful.123 The Commission now appears to accept that most
116
118
120
121
122
123
2007 Monitor, p. 13 and 2008 Monitor, p. 14. 117 2007 Monitor, p. 13.
See further ch. 6. 119 BME Report, pp. 211–14.
U. Reifner et al., Final Report: Part I: General Analysis: Impact of Directive 2002/65/EC.
Project No. SANCO/2006/B4/034 (2008).
As well as factors related to understanding local markets, payment structures, credit
assessment and recovery and diverging rules, particularly on money-laundering: Civic
Consulting, Analysis of the Economic Impact of Directive 2002/65/EC: Final Report (2008).
European Commission, Green Paper on Retail Financial Services, pp. 4–5.
The consultation on the 2007 Green Paper revealed that most respondents saw retail
markets remaining local for the foreseeable future given the importance of language,
22
the retail investor and the ec
consumers of retail financial services are likely to remain domestically
focused. Although it has suggested that further reforms may be necessary,
it will only proceed where appropriate and where there is evidence of clear
and concrete benefits.124
This realization of the limits of harmonization in driving cross-border
activity coupled with the ever-increasing ambition of EC retail market
policy points, however, to the importance of the regime as a regulatory
system.
4. But room for local ‘law on the books’ and for ‘law in action’:
the UK example
The EC regime is not, however, monolithic. Some room remains for
regulation to reflect the different features and risks of Member States’
markets.
MiFID and the related UK investment advice and product distribution
regime provides a useful illustration of the ability of Member States to
retain discrete rules ‘on the books’ which respond to local risks. Investor
protection in the UK retail investment markets125 is primarily a function
of the Financial Services and Markets Act 2000 (FSMA) under which the
FSA operates and which, under section 2, imposes a series of statutory
objectives, including consumer protection and public awareness, with
which FSA activities must be compatible (chapter 2); the harmonized
regime, by contrast, does not engage with the over-arching principles
with which local regulators should act and which could lend coherence
to ‘law in action’ strategies in particular. FSMA also imposes the central
authorization obligation for ‘regulated activities’ in the financial services
sector; a person may not engage in ‘regulated activities’ unless that person is authorized or exempt (section 19). ‘Regulated activities’ essentially
relate to ‘specified activities’ and ‘specified investments’ (section 22(1))
which are set out in the related Regulated Activities Order126 which covers
124
125
126
culture and the familiarity of consumers with local providers. A senior FSA official has
similarly suggested that stakeholders need to be realistic in their expectations as to what
can be done through regulation to encourage consumers to do more cross-border business:
D. Waters (FSA), Speech on ‘MiFID, Threats and Opportunities’, 9 January 2008, available
via www.fsa.gov.uk/Pages/Library/Communications/Speeches/index.shtml.
European Commission, Green Paper on Retail Financial Services, p. 6.
This section is an outline discussion only. See further I. MacNeill, An Introduction to
the Law on Financial Investment (Oxford and Portland, OR: Hart Publishing, 2004),
pp. 59–78, 91–135 and 165–85.
Financial Services and Markets Act 2000 (Regulated Activities) Order 2001.
the retail markets and the ec
23
EC requirements as well as those additional activities specified by the
Order. ‘Specified activities’ in the investment services sphere include
advising on investments as an agent of the investor as well as the other
central retail market activities covered by MiFID127 (such as managing
investments and safeguarding and administering investments) and exMiFID activities such as establishing, operating and winding up collective
investment schemes; ‘specified investments’ extend to a wide range of
investments.128 By contrast with the MiFID regime, FSMA also imposes
an additional discrete authorization requirement on particular individuals
through the ‘approved persons’ regime which limits ‘controlled functions’
to ‘approved persons’ (section 59) and which reinforces both ex ante
investor protection regulation and ex post enforcement.129 Alongside the
authorization regime, FSMA also imposes a financial promotions regime
which prohibits financial promotions by persons who are not authorized
(section 21).
In addition to these local features which strengthen MiFID’s authorization requirements for advice and distribution, the local regime also
responds to specific UK market features. Investment advice in the UK is
largely delivered by smaller, notionally ‘independent’ investment advice
firms, often termed personal investment firms, which do not manage
investments or hold client assets or funds and which do not deal in investments; these firms simply advise on investments (primarily the ‘packaged
products’ discussed below) and transmit orders in investments to other
regulated entities.130 They are at the heart of the UK investment advice
industry.131 Their limited range of activities, however, means that MiFID’s
127
128
129
130
131
See further ch. 4.
Including government and public securities, shares, debt instruments, derivatives, collective investment schemes, contracts related to life assurance and deposits.
A function may be designated by the FSA as ‘controlled’ where it is likely to enable the
individual responsible for its performance to exercise a significant influence on the conduct
of an authorized person’s affairs (with respect to the regulated activity), where the function
will involve the individual performing it in dealing with customers of the authorized person
in a manner substantially connected with the carrying on of the regulated activity or where
the function will involve the individual performing it in dealing with the property of
customers of the authorized person in a manner substantially connected with the carrying
on of the regulated activity.
Over 5,000 personal investment firms (representing 28,000 investment advisers) provide
advice in the UK market. 83 per cent of these firms have fewer than five advisers, although
firms are increasingly becoming organized in networks and, in some cases, are owned
by product providers: FSA, Review of the Prudential Rules for Personal Investment Firms
(Discussion Paper No. 07/4, 2007), pp. 8–9.
These advisers account for more than 75 per cent of all sales of CISs, for example, and are
seen, based on consumer surveys, as the ‘key conduit between consumers and products’:
24
the retail investor and the ec
weighty authorization and regulatory regime, which responds to a wide
range of investment firm risks, would be costly. But one of MiFID’s more
notable exemptions from investment services authorization (and regulation) relates to ‘Article 3 firms’ which only advise on investments or receive
or transmit orders in transferable securities and units in collective investment undertakings and do not hold investor assets.132 This exemption has
been applied by the UK to its personal investment firm industry. ‘Article 3
firms’ nonetheless carry out ‘regulated activities’ and are subject to FSA
authorization and to a discrete regulatory regime which – in an attempt
to avoid regulatory arbitrage – is closely based on MiFID requirements
where cost benefit requirements have been met.133 But the FSA also has the
freedom to apply a more nuanced regime to the sector, although arbitrage
risks between MiFID and non-MiFID advice firms134 must be managed.
Recent FSA retail reforms have focused closely on this sector and, in particular, on the mis-selling risks with which it is associated (which arise
from a combination of commission-based remuneration, poor investor
discipline and product competition at the distribution level (with respect
to product commissions) rather than at the investor level135 ). The FSA has
engaged in an extensive review of the prudential requirements imposed
on these firms, particularly to limit the impact of latent liabilities where
these firms fail and outstanding liabilities in terms of mis-selling claims
must be met by the industry through the Financial Services Compensation
Scheme,136 and has had the freedom to develop a targeted capital resources
regime for non-MiFID ‘Article 3 firms’.137 The FSA has also addressed misselling risks in this sector through its massive Retail Distribution Review,
132
134
135
136
137
HM Treasury, Notification and Justification for Retention of the FSA’s Requirements on the
Use of Dealing Commissions under Article 4 of Directive 2006/73/EC Implementing Directive
2004/39/EC and Notification and Justification for Retention of Certain Requirements Relating
to the Market for Packaged Products under Article 4 of Directive 2006/73/EC Implementing
Directive 2004/39/EC (2007) (‘UK Article 4 Application’), pp. 12–13.
MiFID, Art. 3. 133 See also ch. 4.
In particular as not all personal investment firms fitting the ‘Article 3’ profile are MiFIDexempt as they have ‘opted in’ to MiFID authorization in order to benefit from the MiFID
‘passport’ (FSA, Review of the Prudential Rules for Personal Investment Firms (Consultation
Paper No. 08/20, 2008), p. 5.
See further ch. 4.
FSA, Discussion Paper No. 07/4, FSA, Review of the Prudential Rules for Personal Investment
Firms (Feedback Statement No. 08/2, 2008) and FSA, Consultation Paper No. 08/20. The
reforms followed concerns that the pre-existing and complex regime was no longer fit
for purpose given failures in the sector and that a new and clearer risk-based model was
required.
The reforms apply only to non-MiFID ‘Article 3 firms’ (FSA, Consultation Paper No.
08/20). Where ‘Article 3 firms’ do not benefit from the exemption, MiFID applies a lighter
capital resources regime, based on insurance cover (see further ch. 4). The FSA’s approach,
the retail markets and the ec
25
although the scale of the review, which covers the whole investment advice
industry and not simply the ‘Article 3’ sector, has led to difficulties with
MiFID (chapter 4).
The tailoring of EC rules to local market features is also evident in
the detailed rules which support the statutory regime and which are set
out in the FSA’s extensive rulebook or Handbook. The Handbook, which
also implements EC requirements, has a number of different sourcebooks
which contain the detailed regulation for the retail markets.138 The COBS
(conduct of business) sourcebook, in particular, is pivotal to investment
advice and distribution, addressing investor classification, investment firm
disclosures, advice and know your client rules, client agreements, marketing, product disclosure and reporting. While it implements MiFID with
respect to investment firms and MiFID investments, it is wider than MiFID
in its scope,139 reflecting the cross-sector nature of product distribution
in the UK and the extent to which ex-MiFID pension products, ex-MiFID
unit-linked insurance products and MiFID investment products substitute
for each other and are sold by advisers. In extending the MiFID regime, the
FSA’s concern has been to meet local concerns by seeking a level playing
138
139
however, is expressly designed to address market failures and mis-selling in the UK personal
investment firm sector and is based on a minimum capital level for all firms (£20,000)
and an ongoing Expenditure Based Requirement which is designed to be risk-based.
The High-Level Standards Block, for example, includes PRIN (the principles for business,
including Principle 6 on fair treatment, which supports the FSA’s important Treating
Customers Fairly regime), SYSC (senior management arrangements, systems and controls), COND (threshold conditions for authorization) and FIT (the approved persons
regime and the related ‘fit and proper’ test). The Prudential Standards Block includes
GENPRU (general prudential requirements), BIPRU (prudential requirements for banks,
building societies and investment firms) and UPRU (prudential requirements for UCITS).
The Business Standards Block includes COBS (conduct of business), CASS (client asset
requirements) and MAR (market conduct and the control of market abuse). The Listing,
Prospectus and Disclosure Block includes LR (the Listing Rules), while the Redress Block
includes DISP (redress) and COMP (compensation). The COLL sourcebook addresses
collective investment.
Unlike the MiFID conduct-of-business regime, the COBS sourcebook applies in principle
to firms with respect to their deposit-taking, designated investment business and long-term
insurance business activities (COBS 1.1.1). But the main retail investment market rules
apply broadly to ‘designated investment business’, which business reflects the definition
in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 of
investment business. By contrast with MiFID’s narrower approach, advice business (which
comes within ‘designated investment business’) is subject to COBS where the advice
concerns ‘designated investments’; these cover a wide range of retail investments, including
life policies, personal pensions and stakeholder pensions, which are excluded from MiFID.
MiFID’s suitability regime, for example, provided the ‘nucleus’ of the COBS suitability
regime for non-MiFID products including life insurance policies, pensions and other
packaged products: FSA, Consultation Paper No. 06/19, p. 76.
26
the retail investor and the ec
field where firms carrying out investment business deal with retail clients,
not differentiating between firms, and ensuring the same standards apply
to competing products.140
The regulation of investment products also illustrates how tailored
domestic regimes can co-exist with the harmonized EC regime. The main
focus of the EC investment product regime, such as it is, is on UCITS
disclosure, UCITS product design and, to a more limited extent, UCITS
governance requirements. The FSMA regime, however, is wider, addressing
‘open-ended’ (in that schemes must redeem investors’ investments on
demand) CISs generally141 and imposing promotion restrictions unless a
scheme is an authorized unit trust, an authorized open-ended investment
company or other recognized scheme142 (or essentially a regulated UCITS
scheme or ‘non-UCITS retail scheme’ (NURS)). The FSA’s Handbook
imposes detailed regulation on regulated schemes which are authorized
for distribution to the public.143 This regime is both deeper and wider than
the UCITS regime. The FSMA/FSA regime for regulated UCITS schemes
is considerably more sophisticated and extensive than the harmonized
UCITS regime.144 But the FSMA/FSA regime is also wider. The nonUCITS NURS regime (which includes future and options schemes and
property schemes145 ) has allowed the FSA to respond to the requirements
of the UK retail market. In implementing a policy decision to expand
retail investor choice with respect to the range of NURS marketed to the
public146 the FSA has, for example, expanded the NURS regime to allow
NURS to invest in funds of hedge funds.147
The UK investment product market also includes ‘closed-end’ investment schemes (which do not redeem investor units or investments on
140
141
144
145
146
147
E.g. FSA Substitute Products Response, p. 2 and Consultation Paper No. 06/19, pp. 79–80
(with respect to the extension of the MiFID suitability rules to ex-MiFID unit-linked
products and ex-MiFID ‘Article 3’ firms).
Defined in FSMA, sect. 235. 142 FSMA, sect. 238. 143 Through the COLL sourcebook.
For a discussion of how the detailed FSA Handbook applies to collective investment
schemes (including UCITS) see E. Lomnicka, ‘Collective Investment Schemes’ in W. Blair
and G. Walker (eds.), Financial Services Law (Oxford: Oxford University Press, 2006),
p. 659 and J. Benjamin, Financial Law (Oxford: Oxford University Press, 2007),
pp. 211–12.
NURS have wider investment powers than UCITS schemes. Although the NURS regime
is not segmented into different schemes and adopts a framework approach, specific rules
apply (with respect to, for example, concentration, borrowing, and spread of assets) to
particular schemes, including property schemes and funds of hedge funds.
FSA, Discussion Paper No. 05/3 and FSA, Funds of Alternative Investment Funds: Feedback
on Consultation Paper 07/6 and Further Consultation (Consultation Paper No. 08/4, 2008).
See further chs. 2 and 3.
the retail markets and the ec
27
demand and so fall outside the UCITS and NURS regime) in the form
of (typically) listed companies which engage in investment business (or
‘investment trusts’) in which investors hold a shareholding. These corporate vehicles, which have a venerable history,148 although they came under
severe pressure over the financial crisis,149 are, for the most part, primarily addressed by company law, by the disclosure and other requirements
which the Prospectus and Transparency Directives impose on listed issuers
and by the Listing Rules applied by the FSA.150 Although domestic issuer
disclosure requirements are a function of the directives, the domestic listing regime has allowed the FSA to tailor the local regulatory regime to
the particular risks of the UK marketplace and to the popularity of these
investments.151 The losses incurred by retail investors following the failure
of the split-capital investment trust sector, for example, led to reforms
to the listing regime and, in particular, to a requirement that investment
trust boards be independent from investment managers given the possibility for conflicts of interest.152 While MiFID imposes high-level admission
to trading requirements on transferable securities (including shares in
investment companies and trusts),153 the Listing Rules for closed-end
schemes/investment trusts are considerably more tailored.154
The UK investment product regime also responds to the particular risks
which arise from local industry structures and retail investor behaviour.
148
149
150
151
152
153
154
The Foreign & Colonial Investment Trust, for example, was established in 1868.
S. Johnson, ‘Rescue Plan for Investment Trusts’, Financial Times, Fund Management
Supplement, 9 February 2009, p. 1.
Listing Rule 15. Listing requirements also apply to open-ended schemes (Listing Rule
16) but these are much less extensive as open-ended schemes marketed to the public are
subject to the detailed FSMA/FSA regime.
Over 430 investment entities are represented on the UK Official List (amounting to £66
billion): J. Tiner (FSA), Speech on ‘Listing Rules Reform and the FSA’s Approach to Better Regulation’, 20 March 2006, available via www.fsa.gov.uk/Pages/Library/index.shtml.
Although retail investment in this sector is significant, wholesale institutions remain dominant, with two-thirds of the investment institutional in nature: Benjamin, Financial Law,
p. 212.
FSA, Investment Companies: Proposed Changes to the Listing Rules and the Conduct of
Business Rules: Changes to the Model Code (Consultation Paper No. 164, 2003).
Through MiFID, Art. 40(1) (financial instruments generally must be capable of being
traded in a fair, orderly and efficient manner and transferable securities must be freely
negotiable) and the related level 2 (delegated rules) regime.
Listing Rule 15 includes the requirements that closed-end investment schemes must:
invest and manage assets in a way consistent with their objective of spreading risk; avoid
cross-financing between the businesses which form part of their portfolios; invest no
more than 10 per cent of assets in other listed closed-end schemes; publish an investment
policy which covers asset allocation, risk diversification and gearing; and meet board
independence requirements.
28
the retail investor and the ec
In principle, FSA regulation of the retail investment services and products market seeks to ensure a level playing field between firms which
deal with retail clients and investments and does not generally distinguish between firms or with respect to different products, thereby limiting the scope of regulatory arbitrage in the UK. But the popularity
of substitutable, cross-sector investment products in the UK (including
UCITS, NURS, investment trusts, pension products and unit-linked insurance products),155 well-documented evidence of poor investor decisionmaking156 and reliance on commission-based advisers157 has also led the
UK regime to focus sharply on the cross-sector risks of product sales and
to attach discrete regulation to particular products.
By contrast with the segmented EC approach, the FSA has developed a
specific and targeted cross-sector regime for the distribution of, and advice
with respect to, ‘packaged products’ or complex and long-term investment
products which are sold to the mass market, typically by commissionbased (usually ‘Article 3’) advisers. Personal pension products, units in
regulated CISs (including UCITS), investments in investment trust saving
schemes (not all investment trusts) and unit-linked life insurance products, and whether or not they are held within tax wrappers or constructed
as ‘stakeholder products’ (see chapter 3),158 are all packaged products and
so are subject to tailored distribution and disclosure requirements under
COBS. These products have in common generally complex structures,
commission-based sales and a mass market orientation – the packaged
products regime is designed to be calibrated to the investing patterns of
the UK retail investor. The regime does not include equities, in part as
they are less opaque and as they are not generally actively traded by retail
investors.159 Shares in investment trusts are not, accordingly, included
within the regime. But, where a trust provides a regular savings mechanism and competes with other investment and savings products, it is
treated as a packaged product as, under the FSA’s analysis, it then becomes
substitutable with other mass market savings and investment products.160
The additional packaged product requirements include disclosure obligations, in that a ‘Key Features Document’, which is similar in design to
the UCITS simplified prospectus, must be prepared by product providers
155
158
159
160
Sect. III below. 156 See further ch. 2. 157 See further ch. 4.
Definition of packaged product, FSA Handbook, Glossary. Stakeholder and personal
pensions are also packaged products.
FSA Substitute Products Response, p. 3.
Investment Trust Savings Plans represented only 10,000 of the 844,000 investment products
sold in 2007–8: FSA, Retail Investments Product Sales Data Trends Report September 2008
(2008), p. 8 (a 50 per cent drop from 2006–7).
the retail markets and the ec
29
and provided at the point of sale, a requirement to disclose commissions
and commission equivalents prior to a sale, a requirement to explain recommendations in writing and controls on when a firm can describe itself
as independent.161 Because the FSA’s packaged product regime imposes
requirements additional to the MiFID distribution regime for MiFID
investments and services, it necessitated an Article 4 application to the
Commission.162
Regulation aside, as discussed further in chapter 2, effective retail market intervention depends heavily on ‘law in action’ techniques as well
as on ‘law on the books’. But EC investor protection law and policy is
primarily based on regulatory strategies. ‘Law in action’, in the form
of supervisory and enforcement practices, remains the preserve of the
Member States. The FSA has made full use of this distinction with its
innovative ‘Treating Customers Fairly’ (TCF) strategy. Based on Principle 6 of the FSA’s high-level Principles for Business,163 it addresses the
product life-cycle and the fair treatment of investors through product
design, distribution/advice and redress initiatives. The different TCF initiatives sit within the EC rule framework but are designed to drill below
the regulatory regime and to support the delivery of its objectives and
outcomes.164
5. Examining retail investor protection through the EC lens
Regulatory design ‘on the books’ for retail markets in the Community has,
accordingly, become in large part a function of EC intervention, although
161
162
163
164
A Key Features Document (and other disclosures – the Key Features Illustration) must, in
principle (exemptions apply), be prepared by firms for the packaged products they produce
(COBS 13.1.1) and it must be provided when a firm sells packaged products to retail clients
(COBS 14.2). Commission and commission equivalents must be disclosed in cash terms
when a firm sells, personally recommends or arranges the sale of a packaged product to a
retail client (COBS 6.4.3). A record of the suitability assessment (explaining why certain
recommendations were made) must also be kept with respect to advice concerning certain
products, including CIS units, certain investment trust shares (including those related to
savings schemes), life insurance products and pension products (COBS 9.4.1). The regime
also provides that a firm may not hold itself out as independent in relation to advice
(or personal recommendations) on packaged products unless it intends to look across the
‘whole of the market’ (or the whole of a sector of the market) in making a recommendation
and offers a client a fee (rather than commission) option with respect to the packaged
product transaction (COBS 6.2.15 and 6.2.16).
See further chs. 4 and 5.
Principle 6 of the Principles for Business (set out in the PRIN sourcebook) requires firms
to pay due regard to the interests of their customers and to treat them fairly.
See further chs. 3 and 4.
30
the retail investor and the ec
practical ‘in action’ strategies remain the preserve of the Member States
and there is some room for local flexibility with respect to ‘law on the
books’. The scale of the influence of EC investor protection regulation
and policy on domestic regulation alone calls for close attention.165 But
the regime also provides a rich case study for wider examination of the
purpose of intervention in the retail market and the risks (chapter 2),
for assessing the main regulatory levers used to deliver retail market
objectives (chapters 3 (product design), 4 (distribution), 5 (disclosure)
and 6 (trading)) and for assessing education, investor governance and
supervision and redress in the retail markets (chapters 7 and 8). The
relationship between the EC regime ‘on the books’ and local supervisory and other efforts ‘in action’ similarly provides a useful case study
for illustrating the distinction between ‘on the books’ and ‘in action’
intervention.
But a threshold question must first be asked: who is the retail investor
who is the subject of the EC investor protection regime?
III. Who is the EC investor?
1. Characterizing the target of investor protection
The complexities and risks of retail market regulatory intervention, discussed in chapter 2, are exacerbated by a fundamental difficulty: who is
the retail investor? Descriptive but ultimately meaningless references to
the retail investor,166 the small investor167 and the average investor168 are
scattered across the harmonized regime. In practice, however, ‘the “retail
investor” can be a very hard character or set of characters to pin down’.169
The Commission’s 2007 Green Paper on Retail Financial Services exposed
related differences on the nature of the consumer of financial services,170
while CESR has identified the difficulties in building a model of the retail
165
168
169
170
Ch. 2. 166 MiFID, Art. 4(1)(12). 167 Prospectus Directive, recital 41.
UCITS Directive, Art. 28(3) and MiFID Level 2 Directive, Arts. 27(2) and 38(c).
J. Black, Involving Consumers in Securities Regulation: Research Study for the Taskforce to
Modernize Securities Legislation in Canada (2006), p. 28.
How best to classify the consumer of retail financial services arose during the Commission’s
consultation. There was some support for the consumer as a reasonable, well-informed and
circumspect consumer, although this model was regarded as setting too high a threshold
for consumer protection by user stakeholders: European Commission, A Summary of the
Written Contributions Received on the Green Paper on Retail Financial Services (2007),
p. 21.
who is the ec investor?
31
investor.171 But pinned down the retail investor must be if intervention is
to respond effectively to real risks and not to be a function of regulatory
empire-building or driven by woolly regulator perceptions of the nature of
the retail investor.172 In the EC context, failure to conceptualize the retail
investor carefully raises the additional risk of poorly designed rules which
remove local flexibility.
2. The average EC investor: an elusive target?
a) Investment patterns
The ‘EC investor’ does not exist,173 for the moment at least.174 Evidence
must be drawn from national markets on the investment preferences of
retail investors.175 But, notwithstanding the current policy focus on the
retail markets, only limited evidence has hitherto been available, gathered either nationally or on a pan-EC basis, to inform EC policy and
regulatory design.176 As discussed in chapter 2, one of the more striking
recent trends in retail market policy internationally is regulators’ probing
171
172
173
174
175
176
CESR’s 2005 Retail Investor Workshop highlighted that ‘retail investors’ vary considerably
with respect to their levels of understanding, experience, needs and concerns and underlined the difficulties in capturing the diversity of investors: CESR, Annual Report 2005,
p. 37.
The French regulator, the AMF, for example, has acknowledged the need for its actions
to ‘be based on what savers really want, rather than on what it thinks they want’: AMF,
Promoting Better Regulation: Outcome of the Consultation – The AMF’s Commitments
(2006), p. 8. The hearings on the Commission’s Green Paper on Retail Financial Services
also saw some concern that information ‘be aimed at what best serves the average retail
investor rather than what a regulator thinks’: European Commission, Report of Hearing
on Green Paper on Retail Financial Services (2007), p. 3.
Although one analysis has suggested that the standard French equity holder is similar to
holders in other European countries in that ‘he’ is usually ‘a member of the workforce,
middle-aged . . . and belongs to one of the higher net-worth categories, meaning that
some diversification across several asset types is assumed’, has a superior education and
is receptive to financial information: B. S´ejourn´e, Why Is the Behaviour of French Savers
So Inconsistent with Standard Portfolio Theory? (AMF Working Papers, 2006) (‘French
Savers’), p. 7.
As acknowledged by CESR Chairman Wymeersch, although he suggested that the ‘European consumer’ might emerge: Presentation on Financial Education, Commission Hearing
on Retail Financial Services (2007).
Ch. 2 considers the behavioural vulnerabilities of retail investors. This section addresses
their investment preferences.
Studies can be hard to reconcile. See, for example, V. Corragio and A. Franzosi, Household
Portfolio and Demand for Equity: An International Comparison (Blt Notes No. 19, Borsa
Italiana, 2008), p. 26, which illustrates how domestic data on equity holdings varies across
the EC according to whether the data collected is for direct or indirect holdings, that
32
the retail investor and the ec
of retail market behaviour. The EC’s failure to model the retail investor
must be placed in the context of the grip of the market integration priority as well as the long dominance of supply-side interests. A significant
step forward was taken, however, with the important 2007 BME Report
on long-term, EC retail savings patterns (the report focused on banking products (deposits), pension products (funded pension policies) and
investment products (securities, CISs and life insurance policies with a
savings/investment component)).177
It is now clear that the EC investor protection regime applies to a set
of retail investors who are largely inexperienced with market investments.
The FSAP was adopted at a time of general stock market exuberance and
policy enthusiasm for market investments.178 But retail investor activity has not developed across the Community in the way expected at the
height of the dotcom/day-trading boom of the late 1990s179 and when
the FSAP was adopted.180 Pension products and unit-linked life insurance products181 together represent nearly half of total household longterm savings.182 Unit-linked insurance products sit uneasily within EC
investor protection policy. Although they provide some exposure to market
177
178
179
180
181
182
the entities collating this data vary (private and public entities are involved) and that the
regularity with which it is collected varies.
It focused in particular on eight Member States deemed to provide a representative sample:
the UK, Germany, Italy, France, Spain, the Netherlands, Sweden and Poland.
Best expressed, perhaps, in the 2000 Lisbon Council Conclusions: ‘Efficient and transparent financial markets foster growth and employment by better allocation of capital and
reducing costs. They therefore play an essential role in fuelling new ideas, in supporting
entrepreneurial culture and promoting access to the use of new technologies’: Council
Conclusions, para. 20. Similarly, Internal Market Commissioner Bolkestein’s speech on
‘Making the Most of the Internal Market after Enlargement’, 13 May 2004 (available via
http://europa.eu/rapid/searchAction.do) highlighted the importance of ‘a full integrated
financial market which is capable of channelling our savings into productive investments
at the lowest cost. Financial services is the oil in the machine.’
The Community did not experience mass retail market exuberance over the dotcom period.
Investment research risks, for example, were seen as lower in the UK given the dominance
of institutional investors who were less susceptible to the ‘cult of the star analyst’ which
distorted the US market: FSA, Investment Research: Conflicts and other Issues (Discussion
Paper No. 15, 2002).
US broker Schwab entered the retail market in 1999 but was sold in 2003 following low
levels of retail market activity: P. Coggan, ‘Disillusioned Followers Desert Cult of Equity’,
Financial Times, 21 February 2003, p. 10.
The premium for unit-linked life insurance policies is in part used to purchase life cover and
in part invested in an investment scheme; the return on the policy reflects the performance
of the scheme. Unit-linked policies do not typically offer guaranteed lump sum payments
but reflect the performance of the investments.
BME Report, p. 23. They represented 42 per cent of total long-term savings in 1999 and
47 per cent in 2005.
who is the ec investor?
33
returns, and despite their complexity and risks, they are treated, for the
most part, as insurance, rather than investment, products and largely fall
outside the harmonized investor protection regime. Pension and unitlinked insurance products are followed by bank deposits, at 21% of total
household savings.183 Collective investment schemes come in third place
at 15%.184
Direct investments in shares and bonds are ranked fourth; bonds (fixedincome investments) represent 10% of EC household savings.185 Direct
equity investment by the retail sector is not common186 and – even leaving
aside the effect of the ‘credit crunch’ market convulsions187 – is dropping.
The initial growth of market finance across the Community in the 1980s
and 1990s was reflected in an increase in riskier retail equity investments in
continental portfolios in particular, although UK household equity participation also increased.188 Household share portfolios increased, as a percentage of GDP and between 1980 and 2003, from 8.7% to 49.3% in Italy,
from 15.7% to 49.8% in France and from 4.8% to 18.5% in Germany.189
183
184
186
187
188
189
Ibid., pp. 11, 23 and 34. For a similar finding on the dominance of bank savings, although
based on a smaller sample, see W. de Bondt, ‘The Values and Beliefs of European Investors’
in K. Knorr Cetina and A. Preda, The Sociology of Financial Markets (Oxford: Oxford
University Press, 2005), p. 163, p. 169. In France, for example, short-term bank deposits
and government-supported savings schemes represent 41 per cent of households’ financial
assets, while insurance products represent 41.3 per cent (Delmas Report, Annex IV, p. 1),
while 2005 data shows UK households holding 25.7 per cent of assets in the form of
deposits and 53.8 per cent in insurance and pension reserves: Corragio and Franzosi,
Household Portfolio, p. 19.
BME Report, p. 11. 185 Ibid., pp. 23 and 41.
Limited direct retail investor involvement in the equity markets relates in part to the more
limited embrace of market finance in continental Europe (C. Van der Elst, ‘The Equity
Markets, Ownership Structures and Control: Towards an International Harmonization’
in K. Hopt and E. Wymeersch (eds.), Capital Markets and Company Law (Oxford: Oxford
University Press, 2003), p. 3), although UK retail investors, in a market characterized by
market-based financing, tend to prefer packaged products to direct investments, as noted
below.
Discussed in ch. 2.
UK retail investor holdings in equity increased in the 1980s and 1990s, reflecting the
privatization and demutualization waves. Growth in direct equity-ownership was rapid
during the 1980s, with UK equity levels growing faster than those in the US: J. Banks, R.
Blundell and J. Smith, ‘Understanding Differences in Household Financial Wealth Between
the US and Great Britain’ (2003) 38 Journal of Human Resources 241, 259. Ownership grew
from 2 million in 1979 to 12 million in 1990 and peaked at 15 million in 1997. But most
small investors sold their holdings for a quick return and the ‘anticipated rise in the
number of consumers proactively engaged in the stock market has not materialized’: FSA,
Towards Understanding Consumer Needs (Consumer Research No. 33, 2005), p. 20.
I. Ert¨urk, J. Froud, S. Solari and K. Williams, The Reinvention of Prudence: Household
Savings, Financialization, and Forms of Capitalism (University of Manchester, Centre for
Research on SocioCultural Change, 2005), pp. 10–11.
34
the retail investor and the ec
Higher equity market participation rates were also recorded in the 1990s190
with an increase in the number of households holding equities.191 But
this trend was not sustained.192 The Federation of European Securities
Exchanges’ 2006 share ownership report reported that households represented 15% of total share ownership and that participation had declined
between 1999 and 2005.193 Its 2007 Report similarly reported a ‘continuous decline in the participation of individual investors’ between 1999 and
2007, down to 14% in 2007.194 Similarly, household equity holdings, as
a proportion of household savings, reduced from 12.6% of households’
long-term savings in 1999 to 8.8% in 2005.195 The pan-EC downturn in
equity investments has been related, in part, to the dotcom/Enron-era
market crash and to a wider loss in household confidence in equity market
investment as well as to structural market features, including the growth
of intermediated investments.196 The FSAP policy discovery of the retail
investor appears, therefore, to have coincided with the retreat of a ‘first
cycle’ of direct retail equity investors.197 This has been exacerbated by the
recent severe turbulence in financial markets which has seen some retail
investors revert to intermediated, capital-protected products. But patterns
vary across the EC; Poland, Belgium, Italy and Denmark all experienced
increases in household/individual equity investments prior to the financial
crisis.198 The Dutch market conduct regulator (the AFM) has also reported
190
191
192
193
194
196
197
198
This period saw a movement towards high-return, riskier assets and away from safer
and more liquid assets such as government bonds: L. Guiso, M. Haliassos and T. Japelli,
Household Stockholding in Europe: Where Do We Stand and Where Do We Go? (CEPR,
Discussion Paper No. 3694, 2003) (‘CEPR Household Stockholding’), p. 7.
The percentage of households holding direct equity investments increased from 9 per cent
(1987) to 22 per cent (1998) in the UK, from 4 per cent (1989) to 7.3 per cent (1998) in
Italy and from 10 per cent (1989) to 17 per cent (1998) in Germany: ibid., p. 10.
The BME Report noted that European households experienced a pronounced decline in
the weight of quoted stocks in their portfolios between 1999 and 2005: p. 45.
Federation of European Securities Exchanges (FESE), Share Ownership Structure in Europe
(2006), p. 17.
FESE, Share Ownership Structure in Europe (2007), p. 7. 195 BME Report, p. 45.
FESE, Share Ownership 2006, p. 17 and BME Report, pp. 47 and 48 (noting that, while
markets fell by 8.5 per cent over 1999–2005, total household losses were in the order of
18.5 per cent); and (in the Italian context) A. Franzosi, E. Grasso and E. Pellizzoni, Retail
Investors and the Stock Market: Second Report on Shareholding in Italy (Blt No. 12, Borsa
Italiana, 2004).
In a number of Member States, notably Poland and Greece, shares became a ‘fashionable’
investment for the first time in the 1990s but investors dramatically revised their assumptions as to the wisdom of equity investments following substantial losses: BME Report,
p. 89.
FESE, Share Ownership 2007, p. 21.
who is the ec investor?
35
that a slight downturn experienced after the bursting of the dotcom bubble was followed by a steady rise in the number of private investors (who
invest primarily in collective investment schemes and equities).199
Derivatives are only of marginal importance in the retail market,200
although demand has grown for structured products based on
derivatives,201 particularly in Germany,202 and retail investors are increasingly being exposed to derivative risk through the UCITS III product,
discussed in chapter 3.
Overall, however, evidence is emerging of greater long-term savings
through the markets;203 households and individuals are moving away from
a largely deposit-based/government-securities-based savings culture.204
There is a striking move towards ‘institutionalized’ savings, or savings
through pension funds, insurance companies or collective investment
schemes. Between 1970 and 2003, for example, household savings in bank
deposits as a proportion of household portfolios dropped from 54%,
60%, 49% and 34% in Italy, Germany, France and the UK, respectively, to
27%, 36%, 30% and 26%. Over the same period, institutionalized savings
increased from 8%, 15%, 6% and 23% in Italy, Germany, France and the
UK, respectively, to 28%, 41%, 39% and 54%.205 While pension savings
must account for a very considerable share of this increase, investors have
also become more exposed to direct market investments; appetite for
investments in often complex, risky and opaque structured products, and
in similarly troublesome unit-linked insurance products, is also increasing
(chapter 3). In the future, household savings patterns are likely to reflect
199
200
201
202
203
204
205
AFM, Policy and Priorities, p. 11.
BME Report, p. 77. Although 6 per cent of Italian trades in standard equity derivative
contracts are made online by retail investors: B. Alemanni and A. Franzosi, Portfolio and
Psychology of High Frequency Online Traders: Second Report on the Italian Market (Blt
No. 16, Borsa Italiana, 2006).
In the late 1990s, European exchanges and intermediaries began to develop structured
products based on derivatives which are designed to respond to retail investor needs. The
Warsaw stock exchange, in particular, is regarded as a pioneer of retail derivatives – 70 per
cent of investors in listed derivatives in Poland are individuals: BME Report, pp. 77 and 79.
Deutsche Bank, Retail Certificates: A German Success Story (Deutsche Bank Research, EU
Monitor 43, 2007). More than 6 per cent of German retail investors hold derivatives in
their portfolios (BME Report, pp. 80–1).
E.g. Coraggio and Franzosi, Household Portfolio, p. 19, pointing to a general reduction in
banking intermediation and to an increase in equity and investment fund investments.
Oxera, Description and Assessment of the National Compensation Schemes Established in
Accordance with Directive 97/9: A Report Prepared for the European Commission (2005),
p. 106.
G10 Report, p. 18. A similar study over the 1995–2005 period reports a similar shift in
household portfolios: Coraggio and Franzosi, Household Portfolio, p. 18.
36
the retail investor and the ec
increased reliance on market instruments, whether directly or through
collective investment schemes;206 the potential for the market for private
pensions, but also for direct investment in market instruments, is certainly
considerable.207
b) Diverging investment patterns
But retail investment patterns are very far from homogeneous and risk
appetites vary considerably across the Community.208
Packaged products, and particularly pension and life-insurancerelated (unit-linked) packaged investments, dominate in the UK and
are considerably more popular than direct investments in shares and
bonds.209 Of the 3 million retail investment products sold between April
2007 and March 2008, 1.5 million represented pension products and
almost 850,000 represented ‘investment products’.210 Most investments
in these investment products were in the form of ‘investment bonds’
or investment products which often have an insurance component.211
Insurance-based ‘with profits’ products,212 which are akin to unit-linked
206
207
208
209
210
211
212
Oxera, Description and Assessment, pp. 104 and 105.
Some estimates place the size of the market at €4,000 billion by 2010 and €11,000 billion
by 2030: ibid., p. 104.
‘[T]here are pronounced differences among Member States for virtually every type of
long-term savings instrument’: BME Report, p. 87.
The FSA’s ‘packaged products’ regulatory regime is based on the popularity of these
investments. Packaged products far outstrip direct investments in shares and bonds: UK
Article 4 Application, pp. 10–11. The application highlighted that, while ISAs (Individual
Savings Accounts – a structure which provides tax benefits) can be used as tax shelters
for direct share and bond investments, they are much more commonly used to hold
investments in packaged products. It has also been reported that half of the average
personal spend on financial products relates to pension and superannuation funds and
life assurance premiums: HM Treasury, Financial Capability: The Government’s Long-Term
Approach (2007), p. 9.
Including investment trusts, structured capital-at-risk products, unit trusts, open-ended
investment companies and different bond products: FSA, Retail Investments Product Sales
Data Trends Report September 2008 (2008), p. 2; almost 540,000 sales took the form of
tax-wrapped investments in the form of an ISA.
Ibid., pp. 2 and 8, also reporting that a minority 300,000 of the products sold in the
previous year were collective investments in the form of unit trusts and open-ended
investment companies. Bond products include: distribution bonds, unit-linked bonds
(which represented almost 50 per cent of all bond sales), guaranteed bonds and withprofit bonds.
These products, which are often complex and opaque, and which generate risks with
respect to how the life assurer exercises its discretion, are based on the allocation of
investment returns (from the fund represented by the premiums paid by ‘with profits’
policy-holders) in the form of bonuses which provide ‘smoothed’ investment returns
who is the ec investor?
37
products,213 have been particularly popular,214 although they are becoming less common.215 Insurance-related investments vary in popularity
across the EC, however. While they are popular in France,216 where their
growth has been related to the wider movement of risk from intermediaries to retail investors,217 the Netherlands218 and Poland,219 they are
less common in Germany.220 Reflecting a marked trend to wrap products, which is often related to regulatory arbitrage dynamics, life insurance wrappers are, however, widely used across the EC to distribute CIS
investments.221
UK investors lag behind their continental counterparts with respect to
CIS investments. Most EU-15 Member States display CIS to GDP ratios
of over 20%, while the UK ratio of CISs held by households to GDP is
below 15%.222 But participation rates vary. One study, based on 2005 data,
has identified CIS participation as ranging from a low of 2.5% of household savings in the Netherlands to a high of 17.1% in Belgium.223 CIS
asset allocation preferences also vary considerably with northern households (Netherlands, Sweden and the UK) tending to prefer equity schemes
and Southern households (Italy and Spain) preferring less risky bond
schemes.224 Patterns of UCITS CIS investments, at the heart of the EC
investment product regime, vary considerably. Holdings as a proportion of
household savings now range from 4.1% in the UK to 26.1% in Sweden.225
213
214
215
216
217
220
221
222
224
225
through guaranteed (usually conservative) annual bonuses which are paid when the policy
matures. Terminal bonuses, allocated and paid when the policy matures, reflect the fund’s
actual investment return: MacNeill, An Introduction, pp. 126–7.
Unit-linked products were developed to provide a more transparent form of investmentrelated life assurance and are based not on bonuses but on investment returns linked to
the units in the relevant fund which are allocated to the policy-holder: ibid., p. 127.
The FSA has highlighted the importance of UK cultural preferences in product selection,
pointing to the importance of ‘with-profits’ bonds in the UK market: FSA Substitute
Products Response, p. 9.
Ibid., p. 5.
Delmas Report, p. 7 and Annex IV, p. 2. One-third of insurance investments in 2007 were
unit-linked (AMF, Risks and Trends Monitoring for Financial Markets and Retail Savings
(2007), p. 61).
Delmas Report, p. 7. 218 AFM, Annual Report 2006, p. 44. 219 BME Report, pp. 97–8.
BME Report, p. 67 (linked to local risk-aversion factors).
PricewaterhouseCoopers, The Retailization of Non-Harmonised Investment Funds in the
European Union (2008) (‘2008 PwC Retailization Report’), pp. 9 and 12 (representing
18 per cent of non-UCITS sales in 2007).
BME Report, p. 55. 223 Coraggio and Franzosi, Household Portfolio, p. 18.
BME Report, p. 58.
European Commission, Impact Assessment of the Legislative Proposal Amending the UCITS
Directive (SEC (2008) 2236), p. 7.
38
the retail investor and the ec
Non-UCITS CIS investment patterns also vary, with non-UCITS investment considerably stronger in Germany (which represents 46% of the
total EC non-UCITS sector) and in Luxembourg (14%).226 Divergences
also exist with respect to preferences for cross-border investments. The
Commission’s 2006 Financial Integration Monitor, for example, reported
that only 3% of French investor assets were placed in schemes registered
abroad, while 41% and 36% of German and Belgian assets, respectively,
were placed in non-domestic schemes.227
Particularly sharp differences arise with respect to bond/fixed-income
investments. Germany and Italy together represent more than two-thirds
of total fixed-income investments by Community households: German
households hold 13% of their long-term savings in bonds while Italian
households, strikingly, so hold 32%;228 government debt securities are
the most common Italian household investment.229 Bond investments are
also popular in Denmark, with direct household investment in bonds
accounting for nearly 20% of Danish retail savings and investments in
2003.230 Elsewhere, however, bond investment patterns vary sharply.231
Equity investment patterns also diverge sharply.232 This was clear from
an early stage from the initial equity ‘spurt’ between the early 1980s and
late 1990s which saw marked differences in household enthusiasm for
equity investment across the Member States, reflecting a range of factors
226
227
228
229
231
232
2008 PwC Retailization Report, pp. 6 and 29. By contrast, the non-UCITS sector is very
small in Belgium (0.36 per cent of the EC non-UCITS sector). The UK non-UCITS sector
represents 6.67 per cent. These figures include institutional investment.
2006 Monitor, pp. 21–2.
BME Report, p. 42. The FSA has similarly suggested that, in 2004, Italian households’ direct
investments in bonds accounted for 42 per cent of total Italian retail savings, making Italian
investors the ‘biggest direct retail investors in bonds in Europe’: Trading Transparency in
UK Secondary Bond Markets (Discussion Paper No. 05/5, 2005), p. 14.
CONSOB, Annual Report 2007, p. 82. 230 FSA, Discussion Paper No. 05/5, p. 14.
BME Report, p. 42. In 2004, the average Italian household held more than €12,000 in
fixed income securities, the average German household held €5,800, while the average
British, French and Spanish holding was in the order of €1,000: Centre for Economic
Policy Research (B. Biais, F. Declerck, J. Dow, R. Portes and E.-L. von-Thadden), European
Corporate Bond Markets: Transparency, Liquidity and Efficiency (CEPR, 2006), p. 32.
One report has suggested that direct investment in listed shares is strongest in Germany,
Spain and the Netherlands, followed by the UK: AMF, Risks and Trends Monitoring for
Financial Markets and Retail Savings (2008), p. 60. Similarly, the FESE has reported
that only in Spain and Italy do individual investors hold more than 20 per cent of the
market value of listed shares and that, in seven Member States, individual investors’
holdings represent under 10 per cent of market value: FESE, Share Ownership 2007, pp. 7
and 21. Although the UK is the largest market by capitalization, individual investors’
holdings represent only 12.8 per cent of market value (p. 21).
who is the ec investor?
39
including education, household wealth, pension provision and the relative
importance of CISs and other institutional investors.233 Direct and indirect
holding patterns also vary, with indirect holdings favoured in the UK
(through packaged products), Denmark and the Netherlands, but direct
holdings more common in Spain and Italy.234
Investors have also differed in their response to the financial crisis. While
demand across Europe seems to have shifted from UCITS investments into
deposits and structured products, UCITS outflows have varied across the
Member States with Greece and Portugal recording very strong outflows,
but Sweden reporting inflows for 2008.235
The stakes are, accordingly, high for EC retail market policy. The evidence suggests that investors are generally inexperienced with market
investments and that investment patterns vary sharply across the EC,
increasing the risks of intervention in the retail markets.
3. Investors or consumers?
The emerging evidence points to a retail market which is embryonic and
strongly characterized by the sale of investment products. As discussed in
chapter 2, levels of investor competence are low. Reflecting these themes,
the Commission’s second major empirical study of pan-EC retail investment, the 2008 Optem Report on disclosure, classified investors as either
prudent ‘savers’, who sought ‘safe’ investments, or ‘gamblers’, who were
prepared to take risks.236 It seems reasonable, accordingly, and, given the
policy concern to promote stronger welfare provision by households and
more effective long-term savings, to suggest that prudent, welfare-driven
investment, as well as more discretionary, risk-tolerant investment, should
be reflected in regulatory design. One way of achieving this is for the regulatory system to ensure it captures the investor as a consumer of mass
233
234
235
236
CEPR Household Stockholding, pp. 11–13.
Corragio and Franzosi, Household Portfolio, p. 26. Slightly different findings are noted in
n. 232 above.
European Fund and Asset Management Association (EFAMA), Quarterly Statistical Release
No. 36 (2008).
Optem Report, pp. 8 and 88. Similarly, the French TNS-Sofres Report on regulated disclosures distinguished between ‘savvy investors’, able to control risk through diversification,
and ‘small investors’, who were unwilling to take risks and were concerned to purchase
safe products: TNS-Sofres, Report for the AMF: Investigation of Investment Information
and Management Processes and Analysis of Disclosure Documents for Retail Investors (2006),
p. 8.
40
the retail investor and the ec
market investment products, as well as the investor as a sophisticated
risk-taker.237
There are signs that the retail investor is becoming characterized in
the EC regime as a consumer of investment products and is being subsumed within the wider consumer policy agenda – although investment services remain the responsibility of the Commission’s Internal
Market Directorate General and not the Health and Consumer Protection Directorate General (SANCO) which drives consumer policy and has
responsibility for overlapping areas, notably the DMD.238 Financial services policy is addressed in the Commission’s 2007 general consumer policy
strategy.239 Retail financial market policy discussions in the Commission’s
Financial Services Consumer Group tend to focus on financial products
and on distribution; they only rarely engage with the direct investment
and asset management risks associated with more sophisticated investors.
Current major policy initiatives are also concerned with the investor as
consumer of investment products, notably the substitute products debate
and the UCITS product disclosure reforms (chapters 3 and 5).
There are, however, dangers in adopting a consumer-oriented approach
to investor protection. EC consumer protection policy is strongly associated with consumer choice and consumer empowerment240 and with a
robust model of consumer competence. The Unfair Commercial Practices Directive, for example, relies on whether the economic behaviour
of the ‘average consumer’ would be materially distorted in determining
whether a breach has occurred (Article 5); but the ‘average consumer’
is related to the consumer law jurisprudence of the Court of Justice and
to a ‘reasonably well-informed and reasonably observant and circumspect consumer’. Characterizing the retail investor as a robust consumer
of products, to whom investment is simply one of a series of consumption
decisions and choices,241 may risk over-emphasizing informed choice and
disclosure and risk that firm-facing protections are de-emphasized. It may
237
238
239
240
241
R. Karmel, ‘Reconciling Federal and State Interests in Securities Regulation in the US and
Europe’ (2003) 28 Brooklyn Journal of International Law 495, examining how the investor
as consumer tends to dominate how the US states view investors, while a more robust,
capital-driven approach is taken by the federal system.
SANCO also deals with consumer credit, mortgages, consumer education on financial
services, the payments system and euro-related matters.
European Commission, Communication on EU Consumer Policy Strategy 2007–2013 (COM
(2007) 99).
E.g. European Commission, Communication on Monitoring Outcomes in the Single Market:
The Consumer Markets Scoreboard (COM (2008) 31).
As noted in ch. 2, the use of the term ‘consumer’, rather than ‘investor’, in FSMA has
been associated with a normalization of investment activity: J. Gray and J. Hamilton,
the financial crisis and ec retail market policy
41
also risk that too much is expected of the retail investor. A robust model
of investor behaviour is certainly fast becoming associated with EC retail
market policy which is increasingly concerned to empower and to engage
retail investors (chapter 2). The empowerment model is, however, poorly
equipped to address the risks which are faced by vulnerable investors, seeking to address welfare needs. As discussed in the next chapter, a careful
balance between empowerment strategies and those designed to support
engaged but vulnerable investors, characterized in chapter 2 as trusting
investors, is required when intervening on the retail markets.
IV. The financial crisis and EC retail market policy
The international and EC response to the ‘credit crunch’, which has led to
the deepest world financial crisis since the Great Depression, is evolving
at the time of writing. The reform movement and the policy debates, so
far, have been strongly associated with systemic stability, the credit and
banking system and macro-prudential regulation.242 They have focused
on those actors most closely implicated in the crisis, namely, credit rating
agencies, investment banks and credit institutions, and, perhaps unfairly,
hedge funds and on those rules which, either by failing to support strong
internal risk management, or by reinforcing procyclicality (notably the
Basel capital rules and the mark-to-market principle followed by current
accounting standards), have been linked to the crisis.243 But there are also
important implications for the retail markets as retail market protections
have been placed under pressure in conditions of acute market stress and
as losses in the retail sector have intensified (chapter 2). The search for
yield prompted by historically low interest rates, which led, in part, to
the crisis, was mirrored in the retail markets with increased demand for
alternative investments and complex structured products (chapter 3) and
with heightened regulatory arbitrage and mis-selling risks (chapter 4).
So too was the failure of internal risk management associated with the
banking crisis, with risk management difficulties arising with investment
242
243
Implementing Financial Regulation: Theory and Practice (Chichester: John Wiley & Sons,
2006), p. 192.
E.g. S. Schwarcz, Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown (2008), ssrn abstractid=1056241.
E.g. W. Buiter, Lessons from the 2007 Financial Crisis (CEPR Policy Insight No. 18, CEPR,
2007); M. Brunnermeier, A. Crocket, C. Goodhart, A. Persaud and H. Shin, The Fundamental Principles of Financial Regulation. Geneva Reports on the World Economy 11. Preliminary Conference Draft (ICMB International Center for Monetary and Banking Studies, 2009) and High-Level Group on Financial Supervision, Report (2009) (‘de Larosi`ere
Report’).
42
the retail investor and the ec
schemes and asset custody (chapter 3). Disclosure – always a troublesome
retail market tool – appears all the more so given the severe risks to retail
investors from new products, mis-selling and market risks, which the crisis
exposed, none of which can easily be captured by information techniques
(chapter 5).
In the maelstrom and with the overwhelming preoccupation to stabilize
the world financial system, retail investor interests have not been to the
fore.244 As discussed in chapter 7, regulators have been slow to respond to
retail market risks, and in particular to the crystallization of losses, through
investor education, while the policy debate in the EC has not engaged with
retail stakeholders for the most part, neither have assessments been made
of how households reacted to the crisis.
But the picture is not entirely bleak. Despite the risk that reforms to
the institutional markets and to the international supervisory architecture would overwhelm all other initiatives, work has continued apace in
the EC on key retail market measures, notably the UCITS Key Investor
Information disclosure reform (chapter 5). At Member State level ‘in
action’, the FSA completed its massive consultation on its Review of Retail
Distribution over the worst of the ‘credit crunch’ convulsions in 2008
and consulted on reform proposals in June 2009, although the important
Treating Customers Fairly initiative appears to have been something of a
casualty (chapters 2 and 4).
Specific retail market reforms to the harmonized regime have been limited and have focused, thus far, on reforms to the Investor Compensation
Schemes Directive245 (in part to reflect the autumn 2008 reforms to the
parallel Deposit Guarantee Directive246 as the banking system came under
severe strain).247 On the other hand, and although formal reform proposals are still some way off, the Commission’s enthusiasm in its April
2009 Communication on packaged products for what might be a radical
recasting of the harmonized disclosure and investment advice/product distribution regime in order to capture the risks of investment product sales,
244
245
246
247
A notable exception being the summer 2009 Obama Administration proposal for a Consumer Financial Protection Agency. Scholarship has also been preoccupied with prudential matters, although. Zingales, Future of Securities Regulation, considers the retail market
agenda.
Directive 97/9/EC of the European Parliament and the Council of 3 March 1997 on investor
compensation schemes, OJ 1997 No. L84/22.
Directive 94/19/EC of the European Parliament and Council of 30 May 1994 on deposit
guarantee schemes, OJ 1994 No. L135/5.
European Commission, Directive 1997/9/EC on Investor Compensation Schemes: Call for
Evidence (2009), p. 8.
the financial crisis and ec retail market policy
43
in response to the substitute products question, appears to reflect concern
as to the risks to which retail investors were exposed over the crisis by structured products in particular.248 While it remains to be seen whether the
Commission’s radical and wide-ranging, but still tentative, proposals will
take root, there is no doubting the ambition of the reforms or the Commission’s confidence in asserting its role as the main guardian of Europe’s retail
markets; the crisis may also have encouraged the Commission to present
relatively radical reforms. Institutionally, CESR’s growing attachment to
the retail cause has not abated over the crisis; its ‘credit crunch’ activities
included an assessment of the implications of the Lehman Brothers insolvency for retail investors.249 In a welcome appearance of the retail interest,
the controversial debt markets transparency debate has also been reopened
following liquidity pressures in the debt markets, with CESR appearing
unhappy at the market’s efforts to promote stronger transparency in the
retail markets.250
The most important implications, however, are likely to be indirect
and to follow from the 2009 de Larosi`ere Report which recommended
that a decentralized, networked European Financial System of Supervision be developed, based on home Member State supervision but
also on a transformation of the current Lamfalussy ‘level 3’ committees, including CESR, into independent Authorities with a significantly
enhanced range of supervisory powers, particularly with respect to crossborder and systemic stability risks, and with powers to adopt binding
standards (chapters 7 and 8). The Report was broadly accepted by the
Commission in May 2009. Although the reform is directed towards
systemic stability, it is likely to lead to a significant recharacterization
of CESR’s role and, potentially, prejudice to its retail market agenda
(chapter 7) and may also, in the longer term, have important implications
for retail market supervision with the hint that pan-EC supervision take
the form of a ‘twin peaks’ model, with conduct of business and prudential
supervision in distinct EC institutions.251
248
249
250
251
European Commission, Communication from the Commission to the European Parliament
and the Council: Packaged Retail Investment Products (COM (2009) 204). See further ch. 3.
The Communication was also highlighted in the Commission’s financial crisis submission
to the European Council: European Commission, Communication for the Spring European
Council: Driving European Recovery (COM (2009) 114), p. 7.
CESR, The Lehman Brothers Default: An Assessment of the Market Impact (CESR/09-255,
2009) which focused in particular on the sale of structured products.
CESR, Transparency of Corporate Bond, Structured Finance Product, and Credit Derivatives
Markets: Consultation Paper (2008) (CESR/08-1014, 2008).
De Larosi`ere Report, p. 58.
44
the retail investor and the ec
But, overall, the EC’s attachment to the empowered investor, discussed
in chapter 2, and its scant attention to market risk, have continued in
the face of the titanic market upheavals and widespread destruction of
household wealth, although it is not alone internationally in this regard,
and despite the frequent protestations to rethink regulation. It is this failure
to address whether the ‘why’ and ‘how’ of investor protection, discussed
in the next chapter, should be reconsidered, that raises most concern.
2
Designing a retail investor protection regime
I. Why intervene in the retail markets? Encouraging the
empowered investor, shielding the irrational investor or
supporting the trusting investor?
1. Characterizing investor protection
The EC investor protection regime is ultimately a creature of political
compromise1 and is closely tied to market integration priorities. But it
also forms an extensive regulatory regime which demands challenge and
contextualization. This chapter uses the EC regime and aspects of UK
implementation, in particular, ‘in action’ to examine the nature of retail
investor protection regulation. Chapter 1 considered the ‘who’ of EC
investor protection; this chapter considers the ‘why’ (section I), ‘why not’
(or the risks of intervention) (section II) and the ‘how’ (section III).
‘Investor protection’ has considerable intuitive appeal and dominates
as a regulatory objective internationally.2 But it remains a controversial
justification for intervention. Sharp distinctions arise between characterizations of investor protection as, for example, a threat to entrepreneurialism and efficient capital-raising,3 as an expression of social virtues4 and as
1
2
3
4
As in the related consumer protection sphere: ‘aspects [of the regime] are, like many areas of
any legislature’s output, the result of political expediency rather than considered selection
among available regulatory techniques’: S. Weatherill, EU Consumer Law and Policy (2nd
edn, Cheltenham: Edward Elgar, 2005), p. 85.
IOSCO’s by-laws state that securities regulators should ‘be guided by a constant concern
for investor protection’: IOSCO, Objectives and Principles of Securities Regulation (IOSCO,
2008), p. 1.
‘It has become something of an intellectual gaffe for a serious securities scholar to suggest
that investors might actually need some investor protection to prevent their exploitation’: L.
Stout, ‘The Investor Confidence Game’ (2002–3) 68 Brooklyn Law Review 407, 413. Similarly,
tension has been identified between competing characterizations of securities regulation as
threatening entrepreneurialism and as addressing abuses of economic power: D. Langevoort,
Managing the Expectations Gap in Investor Protection: The SEC and the Post-Enron Reform
Agenda (2002), ssrn abstractid=328080, pp. 4–5.
D. Langevoort, ‘Re-reading Cady Roberts: The Ideology and Practice of Insider Trading
Regulation’ (1999) 99 Columbia Law Review 1319, 1326–9.
45
46
designing a retail investor protection regime
a moral imperative.5 The retail investor has been cast as a central figure in
contemporary capitalism, forming part of a wider cultural legacy which
dates to nineteenth-century globalization.6 But the retail investor can also
be regarded as a disruptive force.7
Investor protection has traditionally been concerned with the defensive protection of the vulnerable investor against unscrupulous market
participants.8 Under neo-classical economics regulatory analysis,9 however, protection is necessary only where market failures, primarily related
to information asymmetries, arise. This analysis typically characterizes
the appropriate regulatory response as information-based and as allowing investors to engage in efficient bargains.10 Information failures are
exacerbated by the credence nature of often complex investment services and products and by investors’ difficulties in comparing investments and assessing long-term performance.11 Information risks also
flow from the significant potential for incentive misalignment in the
principal/agent relationship which characterizes the investor/intermediary
relationship.12 Retail investors also have limited ability to bargain for protections and to monitor intermediaries. Adverse selection becomes likely
with investors differentiating on price rather than on quality, ‘lemons’ (or
poor-quality products or services) dominating13 and the market becoming
less efficient.14
Market failure analysis, with its emphasis on the correction of information asymmetries, is strongly associated with the preservation of
individual autonomy and tends to promote minimal intervention. But
5
6
7
8
9
10
11
12
13
14
B. Black, Are Retail Investors Better Off Today? (2008), ssrn abstractid=1085744.
A. Preda, ‘The Investor as a Cultural Figure of Global Capitalism’ in K. Knorr Cetina and
A. Preda, The Sociology of Financial Markets (Oxford: Oxford University Press, 2005), p.
141.
C. Bradley, ‘Disorderly Conduct and the Ideology of “Fair and Orderly Markets”’ (2000)
26 Journal of Corporation Law 63.
R. Clark, ‘The Soundness of Financial Intermediaries’ (1976) 86 Yale Law Journal 1, 26.
Which is increasingly used by regulators: for example, DG Internal Market and Services
Working Document, Report on Non-Equities Market Transparency Pursuant to Article 65(1)
of Directive 2004/39/EC on Markets in Financial Instruments (2008) (one of the first clear
examples of market failure analysis by the European Commission).
Consumer policy has taken a similar journey from assuming malpractice and abuse to
addressing information failures: G. Howells, ‘The Potential and Limits of Consumer
Empowerment by Information’ (2005) 32 Journal of Law and Society 349.
H. Garten, ‘The Consumerization of Financial Regulation’ (1999) 77 Washington University
Law Quarterly 287.
See further ch. 4.
G. Akerlof, ‘The Market for “Lemons”: Qualitative Uncertainty and the Market Mechanism’
(1970) 84 Quarterly Journal of Economics 488.
J. Black, Rules and Regulators (Oxford: Oxford University Press, 1997), p. 141.
why intervene in the retail markets?
47
paternalism,15 long regarded with hostility by the efficiency school,16 is
also associated with investor protection. It is less concerned with information and more associated with intervention for the individual’s ‘own
good’.17 This more defensive approach to investor protection tends to
lead to heavier intervention in the investor/investment firm relationship
and in the design and distribution of investment products.18 Models of
paternalism have, however, become more nuanced with the advent of the
behavioural finance school of analysis.19
But investor protection is increasingly becoming a proxy in the policy
debate for a more muscular and transformative rationale for intervention;
it is now closely concerned with the promotion of market-based savings.
This development suggests that, as discussed below, the ‘why’ of investor
protection now has three interlinked elements: should retail market regulation encourage the empowered investor, shield the irrational investor or
support the trusting investor?20
2. The retail investor as an agent of public policy and the
empowered investor
a) Public policy and marketing the markets
Long-established US scholarship relates investor protection to capitalraising;21 investor protection is justified where it supports issuers by
reducing the cost of capital, particularly by signalling issuer quality to
15
16
17
18
19
20
21
A. Ogus, ‘Regulatory Paternalism: When Is It Justified’ in K. Hopt, E. Wymeersch, H. Kanda
and H. Baum (eds.), Corporate Governance in Context (Oxford: Oxford University Press,
2005), p. 303.
J. Arlen, ‘Comment: The Future of Behavioral Economic Analysis of Law’ (1998) 51 Vanderbilt Law Review 1765; and Ogus, ‘Regulatory Paternalism’, p. 304.
C. Camerer, S. Issacharoff, G. Loewenstein, T. O’Donoghue and M. Rabin, ‘Regulation for
Conservatives: Behavioral Economics and the Case for Asymmetric Paternalism’ (2002–3)
151 University of Pennsylvania Law Review 1211.
J. Benjamin, Financial Law (Oxford: Oxford University Press, 2007), p. 18.
Leading contributions include R. Thaler and C. Sunstein, ‘Libertarian Paternalism’ (2003)
93 American Economic Review 175.
One vivid characterization has described the potential identities of the retail investor
as variously: ‘an independent risk-taker . . . a prudent saver simply requiring regulatory
assistance in the form of enforced information disclosure, a hapless, relatively uninformed
victim in need of regulatory protectiveness . . . and . . . as a risk-averse individual who wants
something for nothing’: M. Condon, Making Disclosure: Ideas and Interests in Ontario
Securities Regulation (Toronto, Buffalo and London: University of Toronto Press, 1998),
p. 231.
E.g. F. Easterbrook and D. Fischel, ‘Mandatory Disclosure and the Protection of Investors’
(1984) 70 Virginia Law Review 669; and R. Romano, ‘Empowering Investors: A Market
Approach to Securities Regulation’ (1998) 107 Yale Law Journal 2359.
48
designing a retail investor protection regime
the marketplace and by standardizing disclosure. Market-facing concerns
are also evident in the related investor confidence rationale which has
been strongly associated in the US market with a positive view of market investment22 and with wider market efficiency and capital allocation
goals.23 The massive US issuer disclosure system, in particular, has been
linked to the risk that small investors might withdraw their capital.24 Under
this model, the ‘confident’ retail investor is a public policy agent of the
capital-raising process and an instrument of regulatory efforts to promote
market efficiency.25
Although it has had immense influence on the US debate, this analysis is closely associated with issuer disclosure policy, capital-raising and
direct market investing; it has limited direct resonances with the Community retail market which is dominated by intermediation and by indirect
investment in investment products. But there are echoes of this instrumental approach to investor protection in the initial association between
harmonization and market integration in EC securities regulation. The
pre-FSAP phase of EC securities regulation did not address the retail markets in any detail; nonetheless, it characterized the investor as a capital
supplier and integration agent, and regarded investor confidence, built
on harmonization, as a driver of market integration and cross-border
investment.26 This theme recurred in the FSAP and post-FSAP periods
with the policy arguments including that ‘private sector savings in Europe
amount to some 20% of GDP – a valuable asset, if efficiently used, to stimulate growth and job creation’,27 the importance of ‘access to the widest
possible pool of potential investors’ and the need to ‘mobilise household
savings’28 and the link between market participation and wider economic
growth.29
22
23
24
25
26
27
28
29
D. Langevoort, ‘Selling Hope. Selling Risk. Some Lessons from Behavioral Economics about
Stockbrokers and Sophisticated Investors’ (1996) 84 California Law Review 627, 674.
D. Ruder, ‘Balancing Investor Protections with Capital Formation Needs after the SEC
Chamber of Commerce Case’ (2005) 26 Pace Law Review 39.
F. Easterbrook and D. Fischel, The Economic Structure of Corporate Law (Cambridge, MA:
Harvard University Press, 1991), p. 226.
Similar concerns have motivated the regulation of securities markets in Ontario: Condon,
Making Disclosure, pp. 59 and 169.
E.g. European Commission Recommendation 77/534/EEC concerning a European code of
conduct relating to transactions in transferable securities, OJ 1977 No. L212/37, para. 2.
European Commission, Second FSAP Report May 2000, p. 3.
European Commission, Communication on Upgrading the Investment Services Directive
(COM (2000) 727), pp. 5–6.
The 2007 Financial Education Communication assumed that ‘[c]itizens who become confident in investing can provide additional liquidity to capital markets, which can be fed
why intervene in the retail markets?
49
A market-facing and instrumental approach to investor protection is
now, however, closely associated with the retail investment markets. Governments have begun to promote stronger household market engagement
and to identify the retail investor as an agent of a public policy commitment to financial independence. Investor protection law and policy
is accordingly embracing a related ‘marketing’ or transformative dimension. Internationally, the US Securities and Exchange Commission (SEC)
has been characterized as promoting widespread market participation30
by ‘marketing’ the markets as safe and fair,31 while ASIC, the Australian
market conduct regulator, has characterized regulation as a means of
promoting retail investor market participation.32 In Europe, France’s
Delmas Report warned that mis-selling and poor product design could see
a flight from equities and, in consequence, poor capital allocation, prejudice to long-term saving and ‘prompt [an] aversion’ to the market,33 while
the French AMF has suggested that limited household exposure to the
financial markets suggests poor household diversification, inappropriate
investment horizons and inefficient asset allocation.34
In the UK, government and regulatory initiatives, related to the withdrawal from welfare provision, have sought to promote market savings.35
The Treasury has recently supported the FSA’s ground-breaking Retail
Distribution Review (RDR) as a means of supporting stronger engagement with financial services.36 Earlier, the 1980s privatizations attempted
30
31
32
33
34
35
36
through to small-business financing in the EU, a key element in supporting growth and
jobs’: European Commission, Communication from the Commission, Financial Education
(2007), p. 4.
R. Karmel, ‘Reconciling Federal and State Interests in Securities Regulation in the US and
Europe’ (2003) 28 Brooklyn Journal of International Law 495 and L. Stout, ‘The Unimportance of Being Efficient: An Economic Analysis of Stock Market Pricing and Securities
Regulation’ (1988) 87 Michigan Law Review 613.
Langevoort, ‘Re-reading Cady Roberts’ and D. Langevoort, ‘Taming the Animal Spirits of
the Stock Markets: A Behavioral Approach to Securities Regulation’ (2002) 97 Northwestern
University Law Review 135.
ASIC’s deputy chairman has highlighted the importance of considering the ‘steps towards
the virtuous centre that retail investors need to complete the journey, to get to the centre
where they invest confidently and have adequate long term savings’: J. Cooper (Deputy
Chairman ASIC), ‘Retail Investors – What More Can or Should We Do to Help Retail
Investors Build Long-Term Wealth?’, ASIC Summer School July 2008 Papers, p. 5.
J. Delmas-Marsalet, Report on the Marketing of Financial Products for the French Government
(2005) (‘Delmas Report’), p. 12.
AMF, Risks and Trends Monitoring for Financial Markets and Retail Savings (2008), p. 83.
J. Gray and J. Hamilton, Implementing Financial Regulation: Theory and Practice (Chichester: John Wiley & Sons, 2006), pp. 187–8.
HM Treasury, Financial Capability: The Government’s Long-Term Approach (2007), p. 17.
50
designing a retail investor protection regime
to promote wider stock market participation.37 The cornerstone Financial
Services and Markets Act 2000 has been described as forming part of a
wider government strategy for ‘enticing’ investors into the marketplace.38
FSMA can certainly be read without too much difficulty as promoting
an essentially benign view of the markets. The adoption of consumer
protection, public awareness and market confidence as statutory objectives for the FSA by FSMA,39 the Act’s highlighting of proportionality,
innovation and competition in the principles of good regulation which
the FSA must follow40 and the FSA’s heavy reliance on disclosure (often
reflecting EC requirements) and on financial capability techniques,41 have
been assessed as amounting to a commitment to the markets as wealth
creators and as promoting informed and competent retail investor engagement with the financial markets.42 Major policy reviews, such as the 2002
Sandler Review on investment product distribution, which was designed
to support greater mass participation through a suite of simple investment
products,43 have a similar orientation. The FSA’s major recent retail market initiatives (including its financial capability strategy44 and the Retail
Distribution Review45 ) and retail market discussions in its recent Financial
37
38
39
40
41
42
43
44
45
The British Telecom and British Gas campaigns have been described as communicating
a belief that share ownership was not only a game played by the rich and famous: FSA,
Towards Understanding Consumers’ Needs (Consumer Research No. 35, 2005), p. 31.
Gray and Hamilton, Implementing Financial Regulation, pp. 192–7.
FSMA, sect. 2(1) and (2). The market confidence objective has been interpreted by the FSA
in terms of a strategic aim to ensure that consumers (and other market participants) have
confidence that markets are efficient, orderly and clean: FSA, Annual Report 2002–2003,
p. 61.
FSMA, sect. 2(3).
See further chs. 5 and 7. These strategies reflect FSMA’s public awareness objective (sects.
2(1) and 2(2)(b)) and the connection made in the Act between ‘appropriate’ consumer
protection and the needs consumers may have for advice and accurate information (sects.
5(1) and 5(2)(c)).
Gray and Hamilton, Implementing Financial Regulation, p. 194. The FSA has been analyzed
as carrying out a ‘social marketing’ function: J. Devlin, ‘Monitoring the Success of Policy
Initiatives to Increase Consumer Understanding of Financial Services’ (2003) 11 Journal of
Financial Regulation and Compliance 151.
The Sandler Report, Medium and Long-Term Retail Savings in the UK: A Review (2002)
(‘Sandler Report’), p. 35. It was supported by a Basic Advice regime which was designed in
part to encourage consumers to buy products: FSA, A Basic Advice Regime for the Sale of
Stakeholder Products (Policy Statement No. 04/22, 2004), p. 7.
The FSA has linked its capability initiatives to people buying more products: FSA, Towards
a Strategy for Financial Capability (2003).
See further ch. 4. During the RDR, the FSA pointed to the importance of generic advice
services in encouraging savings (A Review of Retail Distribution (Discussion Paper No. 07/1,
2007) (‘2007 RDR’), p. 31), argued that sales services (as distinct from advised services)
could encourage higher levels of savings (Retail Distribution Review – Interim Report (2008)
why intervene in the retail markets?
51
Risk Outlooks are accompanied by a broadly positive rhetoric on market
investments. In its 2003 Risk Outlook, for example, the FSA warned that,
notwithstanding volatile equity markets, diversified investment strategies
should include equities and that investors would face opportunity costs
from an unwarranted loss of confidence in equities.46 The 2006 Outlook
noted the risk that, given the need for individual financial responsibility
for long-term savings, consumers might invest less and be less likely to
take advantage of financial services.47 The 2007 Outlook similarly pointed
to deterrence risks and to the risks related to any reduction in the availability of financial advice.48 As discussed in section I.2.d below, the financial crisis has not noticeably blunted FSA concern to promote market
engagement.
This recasting of investor protection regulation from being defensive
to amounting to a quasi-marketing strategy can also be seen in the recent
evolution of EC law and policy. At an early stage of the FSAP, a senior
Commission official suggested that, post-Enron, ‘the prospect of a European retail equity culture has been dealt a severe blow’.49 Post-FSAP, the
2005 White Paper on Financial Services linked regulation to more effective engagement with financial products as governments limited social
security.50 The 2007 Green Paper on Retail Financial Services included
investment products among the savings products ‘essential for the everyday lives of EU citizens’ and necessary for long-term planning and protection against unforeseen circumstances.51 Similarly, the European Parliament’s response to the Commission’s 2007 Communication on consumer
policy52 assumed that some encouragement to use financial products was
appropriate.53 Support of market investment is implicit across the FSAP,
46
48
49
50
51
52
53
(‘2008 Interim RDR’), p. 2) and suggested that the majority of consumers of investment
products needed help to identify needs and ‘to encourage them to take action’ (Feedback
Statement No. 08/6 (Feedback Statement No. 08/6, 2008) (‘2008 RDR Feedback Statement’),
pp. 26 and 56).
FSA, Financial Risk Outlook 2003, p. 10. 47 FSA, Financial Risk Outlook 2006, p. 80.
FSA, Financial Risk Outlook 2007, pp. 10 and 90.
Speech by Director-General Schaub of the Internal Market Directorate General on ‘Economic and Regulatory Background to the Commission Proposal for Revision of the ISD’,
15 October 2002, available via http://europa.eu/rapid/searchAction.do.
European Commission, White Paper on Financial Services Policy 2005–2010 (COM (2005)
629), p. 7 and Annex III, pp. 10–11.
European Commission, Green Paper on Retail Financial Services in the Single Market (COM
(2007) 226), p. 4.
European Commission, Communication on EU Consumer Policy Strategy 2007–2013 (COM
(2007) 99).
European Parliament, Committee on the Internal Market and Consumer Protection, Report
on EU Consumer Policy Strategy 2007–2013 (A6-0155/2008), para. 28.
52
designing a retail investor protection regime
but particularly in two cornerstone measures: the Prospectus Directive54
(direct investment and disclosure in the primary markets); and MiFID55
(advice and distribution of investment products in the secondary markets).
The Prospectus Directive ambitiously promotes a pan-European retail
equity market;56 in consequence, it is not unreasonable to assume that, on
the demand side, it is also designed to support wider retail engagement.
The Commission placed MiFID, which has been associated with stronger
investment activity,57 in the context of ‘investors turn[ing] to marketbased investments as a means of bolstering risk-adjusted returns on
savings and for provisioning for retirement’.58 It was described by the European Parliament’s powerful ECON Committee as designed to encourage
market savings.59 On its market application in November 2007, the Commission similarly argued that MiFID would support investors in maximizing returns on savings and help to guarantee a higher standard of living.60
This pro-market perspective, and the related characterization of investor
protection regulation as a means of promoting the markets, is also evident
in the pervasive investor confidence rhetoric,61 which has survived the
54
55
56
57
58
59
60
61
Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003
on the prospectus to be published when securities are offered to the public or admitted to
trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64 (‘Prospectus Directive’).
Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on
markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC
and Directive 2000/12/EC of the European Parliament and of the Council and repealing
Council Directive 93/22/EEC, OJ 2004 No. L145/1 (‘MiFID’) and European Commission
Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating
conditions for investment firms and defined terms for the purposes of that Directive, OJ
2006 No. L241/26 (‘MiFID Level 2 Directive’).
E.g. L. Burn and B. Wells, ‘The Pan-European Retail Market – Are We There Yet?’ (2007) 2
Capital Markets Law Journal 263 and ICMA (International Capital Markets Association),
Letter to the Commission on Review of the Prospectus Directive and Regulation, 8 April
2008, Annex (available via www.icmagroup.org), para. 2.1. See further chs. 1 and 6.
More extensive regulation under MiFID has been related to an increase in consumer
confidence and the volume of trade in financial markets: Europe Economics, The Benefits
of MiFID: A Report for the Financial Services Authority (2006) (annexed to FSA, Overall
Impact of MiFID (2006)), pp. 13 and 15.
European Commission, MiFID Proposal (COM (2002) 625), Explanatory Memorandum,
p. 3.
A5-0287/2003.
European Commission, MiFID: Frequently Asked Questions (2007) (MEMO 07/439), p. 4.
The wealth of policy and regulatory examples includes the Prospectus Directive, which
associates disclosure regulation with increasing confidence in securities (recital 18), and
the Commission’s Explanatory Memorandum to MiFID which emphasized the need to
why intervene in the retail markets?
53
financial crisis.62 In its 2009 Communication on packaged products, the
Commission highlighted the collapse in investor confidence and the need
to rebuild confidence, and argued that ‘the foundations for future investor
re-engagement with packaged retail investment products will need to be
laid; people will continue to need to save and invest’.63
b) The empowered investor
Allied to this pro-market and instrumental approach, investor empowerment (typically in terms of informed and active investor decision-making,
investor autonomy, wider investor choice and deeper investor engagement) is increasingly a concern of investor-protection-driven intervention. Investor empowerment reflects a long-standing tradition of investor
autonomy, caveat emptor 64 and individual risk assessment in financial
market regulation.65 But, in its developing form, empowerment is concerned with equipping and encouraging the retail investor to navigate the
financial markets. It focuses in particular on investor-facing disclosure,
financial capability and choice strategies which are designed to support
the achievement by investors of their savings and investment preferences.66
Internationally, empowerment has, for example, been associated with
the recent SEC initiative to ease access by foreign brokers and exchanges
to the US market under a new mutual recognition model.67 Liberalization
through mutual recognition is designed in part to accommodate wider
access by the empowered retail investor to the international markets.68
62
63
64
65
66
67
68
support investor confidence in the wake of the dotcom era scandals: Commission, MiFID
Proposal, p. 4.
The European Parliament in late 2008 noted that ‘educated and confident investors’ can
provide additional liquidity to the capital markets: European Parliament, Resolution on
Protecting the Consumer: Improving Consumer Education and Awareness on Credit and
Finance (P6 TA-PROV(2008)0539, 2008), para. 4.
European Commission, Communication from the Commission to the European Parliament
and the Council: Packaged Retail Investment Products (COM (2009) 204) (‘Packaged Products
Communication’), pp. 1 and 12.
J. Black, Involving Consumers in Securities Regulation: Research Study for the Taskforce to
Modernize Securities Legislation in Canada (2006), p. 15.
H. Jackson, ‘Regulation in a Multisectored Financial Services Industry: An Exploration
Essay’ (1999) 77 Washington University Law Quarterly 319, 333.
T. Williams, ‘Empowerment of Whom and for What? Financial Literacy Education and the
New Regulation of Consumer Financial Services’ (2007) 29 Law and Policy 226.
Although, following a change in SEC leadership and the financial crisis, there have been
few developments since the SEC’s initial efforts in 2008 (e.g. SEC Press Release 2008-49, 24
March 2008, available via www.sec.gov/news/press/2008/2008-49.htm).
The debate was opened in an important article by two senior SEC officials (E. Tafara and
R. Peterson, ‘A Blueprint for Cross-Border Access to US Investors: A New International
54
designing a retail investor protection regime
The interests of retail investors were traditionally regarded as being compromised by, or in tension with, those of foreign firms. But the acceptance
of mutual recognition suggests a reorientation of the SEC’s view of investor
protection and a concern to deliver enhanced diversification opportunities
and lower transaction costs to retail investors.69
Empowerment has also become strongly associated with the FSA’s
retail market strategy.70 The consumer protection objective which, under
FSMA,71 should inform FSA action, is characterized in terms of securing only the ‘appropriate’ degree of protection for consumers (FSMA
section 5(1)).72 An empowerment agenda can also be implied in the inclusion of public awareness73 among FSMA’s objectives for FSA action. The
reliance by FSMA on the term ‘consumer’ rather than on ‘investor’ has
been associated with an empowerment agenda and with a ‘normalization’
of financial product decisions.74 Since 2002, the FSA’s major strategic aim
for the retail markets has been to help consumers achieve a ‘fair deal’.75 The
‘fair deal’ agenda is based on four pillars, two of which (capable and confident consumers; and clear, simple and understandable information76 )
69
70
71
72
73
74
75
76
Framework’ (2007) 48 Harvard International Law Journal 31) which argued that, as retail
investors were increasingly pursuing international investment opportunities, changes in
investor demand suggested that viewing the US markets in isolation was ‘no longer the best
approach to protecting our investors’ (at 32). The SEC’s March 2008 Press Release similarly
emphasizes diversification and lower transaction cost benefits.
H. Jackson, ‘A System of Selective Substitute Compliance’ (2007) 48 Harvard International
Law Journal 105, 110–13.
The National Consumer Council has also supported confident and capable consumers
as being able to plan more effectively for the future and less likely to face mis-selling
risks, capable of making informed choices and promoting effective competition and more
likely to engage willingly with financial services: National Consumer Council, Financial
Capability: The NCC Response to the Treasury Consultation – Financial Capability: The
Government’s Long-Term Approach (2007), p. 4.
FSMA, sects. 2(1) and 2(2)(c).
The FSA must have regard to a series of factors including: the differing degrees of risk in
investment transactions and of consumer experience and expertise; consumer needs for
advice and accurate information; and the general principle that consumers should take
responsibility for their decisions (FSMA, sect. 5(2)).
Including promoting awareness of the benefits and risks associated with different kinds of
investment or other financial dealings, as well as the provision of appropriate information
and advice: FSMA, sects. 2(1) and 2(2)(b) and 4.
Gray and Hamilton, Implementing Financial Regulation, p. 192, suggesting that consumers
are ‘individualistic and acquisitive participants in a market exchange looking after their
own interests and taking responsibility for their choices’.
E.g. FSA, Plan and Budget 2002–2003, p. 11 and, more recently, FSA, Business Plan 2008–
2009, p. 23.
The other two pillars relate to soundly managed and well-resourced firms who treat customers fairly and to proportionate, risk-based and principles-based regulation.
why intervene in the retail markets?
55
rely significantly on disclosure (chapter 5) and education (chapter 7)
techniques. They accordingly reflect a concern to empower investors
which has been implicit in the ‘fair deal’ strategy from the outset.77
Recent FSA strategic initiatives also suggest support for the empowered
investor. The RDR (chapter 4) is based, in part, on supporting ‘capable
and confident consumers’ and on consumers acting as a ‘stronger force’
on the markets, demanding services appropriate to their needs.78 A robust
approach has also been adopted in the products sphere; the new fundsof-hedge-funds regime places a premium on investor choice,79 as does
the FSA’s recent review of the listing rules which apply to investment
entities.80 Consumer responsibility has also emerged as an FSA concern.
An FSA suggestion that retail investors sign an explicit acceptance of
risk, in an attempt to communicate a ‘stronger caveat emptor message’
with respect to riskier products,81 was rejected by the FSA’s consultative
Financial Services Consumer Panel (FSCP) given poor levels of investor
understanding.82 So too was the FSA’s suggestion that specific responsibilities could be imposed on investors.83 In 2008, the FSA returned to
the fray84 with a generally measured discussion of consumer responsibility
and of the balance between consumers’ and firms’ responsibilities.85 While
acknowledging that decision-making weaknesses and market complexity
limit the extent to which responsibility can be expected of consumers, it
nonetheless suggested that in a ‘better world’ consumers would be able to
77
78
80
81
82
83
84
85
The FSA’s initial strategic outcomes for the ‘fair deal’ aim related to consumers: understanding their rights and responsibilities better; demanding high standards and suitable
financial products; undertaking more responsibility for their financial affairs and understanding the financial environment; and understanding the risk/reward trade-off (FSA,
Business Plan 2002–2003, p. 17).
2007 RDR, pp. 3 and 5. 79 See further ch. 3.
The FSA argued that product proliferation should be addressed through greater reliance on
consumer awareness and education strategies rather than on restrictions on the variety of
products available: Implementation of the Transparency Directive: Investment Entities Listing
Review (Consultation Paper No. 06/4, 2006), p. 68.
FSA, Wider Range Retail Investment Products: Consumer Protection in a Rapidly Changing
World (Discussion Paper No. 05/3, 2005), p. 26.
Financial Services Consumer Panel (FSCP), Opinion on Discussion Paper 05/3 (2005),
pp. 2–3.
FSCP, Annual Report 2004–2005, p. 14.
The FSA canvassed in the RDR whether a cross-stakeholder statement of consumers’,
distributors’ and providers’ responsibilities could be agreed: 2007 RDR, pp. 46–7. The
FSCP was hostile, warning that a ‘significant sea change’ in investor competence and ability
to understand disclosure would be required before any such move could be countenanced:
FSCP: Response to Review of Retail Distribution (2007), p. 16.
FSA, Consumer Responsibility (Discussion Paper No. 08/5, 2008).
56
designing a retail investor protection regime
act in their own best interests86 and that ‘markets will work more effectively if consumers are involved and empowered’.87 It set out actions which
the FSA could take in support of greater consumer responsibility and the
‘sensible actions’ which consumers might take. While clearly accepting
limitations to empowerment, the discussion represents a significant statement of intent as to the role of empowered retail investors in a ‘better
world’.
This robust approach to retail investor engagement is not confined to
the UK. The Dutch market conduct regulator has pointed to ‘assertive
consumers’ as a key component of its market regulation strategy and
has emphasized consumer responsibility.88 France’s Delmas Report was
similarly concerned with the transfer of ‘risk and responsibility’ to retail
investors and with ‘teach[ing] consumers to ask the right questions’,89
while empowerment also appears to be a feature of the French regulator’s
thinking.90
EC law and policy has also embraced the empowerment model. The
policy concern to ‘strengthen the demand side’91 has been accompanied
by an ambitious model of the retail investor as autonomous, rational
and empowered,92 driving competition, exerting discipline on the market
and exercising informed choice.93 The Commission’s 2007 Green Paper
on Retail Financial Services committed to empowering consumers of
86
87
88
89
90
91
92
93
‘Better world’ consumers would be financially capable and confident, stay engaged postsale, be willing and able to find the most relevant services and understand and be prepared
to accept the consequences were they not to do so: ibid., p. 29.
Ibid., p. 7.
AFM, Policy and Priorities for the 2007–2009 Period (2007), pp. 6 and 16; ‘when communicating with consumers, the AFM will continue to tell them about their own responsibility’
(at 24).
Delmas Report, pp. 7 and 42.
The AMF has highlighted its role in equipping investors to make informed choices (Response
to Commission Green Paper on Retail Financial Services (2007), p. 1) and that it seeks to
ensure that savers get the information necessary to assess market risk and to make free
choices (Promoting Better Regulation: Outcome of the Consultation – The AMF’s Commitments (2006), p. 8).
European Commission, White Paper on Financial Services, p. 7.
The Parliament has suggested that ‘empowered and educated consumers’ can help to foster
competition, quality and innovation within the banking and financial services industries:
European Parliament, Resolution on Protecting the Consumer, para. 4.
‘By helping to develop better informed, better educated and more confident citizens we
can enable them to take better responsibility for their financial affairs and play an active
role in strengthening the consumer demand side of financial services markets’: Commissioner McCreevy, Speech on ‘Increasing Financial Capability’, 28 March 2007, available via
http://europa.eu/rapid/searchAction.do.
why intervene in the retail markets?
57
financial services to make the right financial decisions for their circumstances, and highlighted the importance of transparency and comparability in strengthening demand and in promoting good investment choices.94
MiFID saw ECOSOC call for the MiFID level 2 regime to be based on a
model of an autonomous, ‘far-sighted, well-informed consumer’95 and the
European Parliament’s ECON Committee repeatedly emphasize investor
autonomy and choice.96 The empowered investor is also regarded as an
agent of market discipline; MiFID’s best execution disclosure regime is
based on the assumption that retail investors will use execution disclosure
to monitor the quality of execution (chapter 6), while the 2006 Investment Funds White Paper called for strong demand-side discipline on the
fund industry.97 The promotion of informed choice has been a particular concern.98 The Distance Marketing of Financial Services Directive
(DMD), the first sustained expression of the EC’s retail market policy, for
example, argued that it was in the interests of consumers to have access
without discrimination to the widest possible range of financial services
(recital 3) and assumes that consumers benefit from easier access to crossborder goods and services.99 The UCITS III investment product regime
(chapter 3) is similarly based on the assumption that empowered investors
benefit from a wide range of investment products; so too are the UCITS
IV reforms.100
The rhetoric of empowerment and choice is already well established in
the related Commission consumer policy.101 If the trend towards characterizing investor protection in terms of products and mass market
savings102 continues, and if consumer and investor protection policy continues to align, this dynamic (and its risks) can be expected to become
more entrenched. Empowerment has certainly cascaded down through
the level 2 and 3 committees, suggesting local political and regulatory
94
95
97
98
99
100
101
European Commission, Green Paper on Retail Financial Services, p. 15.
96
2003 OJ No. C220/1, para. 4.10.
E.g. A5-0287/2003.
European Commission, White Paper on Enhancing the Single Market Framework for Investment Funds (COM (2006) 686) (‘Investment Funds White Paper’), para. 2.
E.g. European Commission, Staff Working Document, White Paper Impact Assessment
(SEC (2005) 1574), pp. 16–19.
European Commission, Green Paper on European Union Consumer Protection (COM
(2001) 531).
The Commission has highlighted the need for UCITS disclosure reforms which would
empower investors, help them to compare products and strengthen their ability to push for
more competition: European Commission, Staff Working Document, Impact Assessment
of the Legislative Proposal Amending the UCITS Directive (SEC (2008) 2236), p. 34.
See further ch. 1. 102 See further ch. 1.
58
designing a retail investor protection regime
support. The level 2 European Securities Committee has supported an
empowerment-based approach.103 So too has CESR at level 3.104 Its 2008
Retail Investor Guide to MiFID, for example, highlighted as its ‘key message’ that the degree of protection received was ‘directly related to the
reliance that [you] place on the firm and on yourself’.105
c) The attractions of the empowerment model
The empowerment model is in many respects attractive and efficient.
It may imply a reduction in regulatory intervention and in the related
risks,106 including those flowing from the assumption that the regulator ‘knows best’. Investor-facing empowerment strategies, typically
disclosure- and education-based, can support investors in achieving individual preferences.107 Disclosure, choice-, and education-based aids can
also be customized by empowered investors who can choose the supports
they need to reflect their needs and preferences.
Empowering strategies, together with ‘marketing the markets’ efforts,
can also be used to lead the investor to exercise sovereignty to achieve
particular regulatory and governmental goals. The ‘responsibilization’ literature examines regulatory policy in terms of government and regulatory
efforts to withdraw from the provision of services and of protection, to
foster greater self-reliance and to make demands of individuals.108 Under
this model, investor protection policy strives to build capable, independent and informed investors who can take on responsibility for welfare
provision.109 The regulatory regime is not neutral as to the merits of market investment; it assumes and drives active participation by informed and
capable investors. Sovereignty and choice are not simply a function of the
investor’s decision; law and policy seek to direct the exercise of sovereignty
and choice to the achievement of policy goals.110
This model also has strong resonances with the characterization of
‘smarter’ or more efficient financial market regulation as being decentred
103
105
106
108
109
110
ESC, Minutes, 11 October 2007. 104 See further ch. 7.
Accompanying Press Release to the Retail Investor Guide (CESR/08-209, 2008), pp. 1–2.
Sect. II below. 107 Williams, ‘Empowerment’, 232.
E.g. Williams, ‘Empowerment’; and I. Ramsay, ‘Consumer Law, Regulatory Capitalism
and New Learning in Regulation’ (2006) 28 Sydney Law Review 9.
The FSA’s approach has been related to its fostering the ‘financial citizen’ as a ‘knowledgeable, competent, confident, self-reliant, and willing market participant’ and a ‘strong
commitment to markets as wealth creators, to competition and innovation, and to the
concept of the individual as a “responsibilized citizen”’: Gray and Hamilton, Implementing
Financial Regulation, pp. 188 and 192–4.
Ramsay, ‘Consumer Law’, 13.
why intervene in the retail markets?
59
in that it embraces a range of disciplining techniques, beyond traditional
command and control regulation.111 Capable and informed investors can
be enrolled as disciplining actors in the regulatory process, monitoring
the market, exerting competitive pressures and accepting responsibility
for their actions; regulation becomes concerned with building ‘responsibilized’ actors who can regulate themselves and the marketplace.112 Regulators can accordingly define the regulated environment and transfer
responsibility for managing risks and market monitoring to the individual; regulators’ responsibility and regulatory risk in an increasingly complex environment can be reduced.113 Empowered and informed investors
can also become agents for the regulator, providing from their market
interactions valuable information which allows the regulator to take more
effective action and to strengthen its position.114
As responsibility is passed to the investor, the retail investor might also
be regarded as becoming the object of blame, and as not taking sufficient efforts to become informed, rather than as the beneficiary of public
protective intervention.115 Mis-selling becomes an occasion of investor
imprudence rather than of regulatory failure.116
The appeal of empowerment-based, investor-facing, disclosure and
capability strategies is considerable to the beleaguered regulator. As discussed in subsequent chapters and in section II below, optimal retail market regulatory design is extremely difficult to achieve, particularly on the
supply side. Product design is an unwieldy retail market lever and the distribution and advice lever is obstructed by conflict-of-interest difficulties.
The strains are increased by the traditional segmented approach to financial market regulation as investment products cross the insurance, banking
and investment sectors. Retail investor input into the law-making process is minimal, but supply-side interests are well organized and typically
ferocious in defending their turf. Demand-side, empowerment-related
111
112
113
114
115
116
E.g. J. Black, ‘Decentring Regulation: Understanding the Role of Regulation and Self
Regulation in a “Post Regulatory World”’ (2001) 54 Current Legal Problems 103.
Williams, ‘Empowerment’, 243; and Gray and Hamilton, Implementing Financial Regulation, pp. 49–50.
Williams, ‘Empowerment’, 242.
The FSA’s exhortations on its ‘moneymadeclear’ website to retail investors to provide it
with instances of unfair contract terms might fall into this category.
L. Willis, Against Financial Literacy Education (2008), ssrn abstractid=1105384, pp. 43–7.
Faint echoes of this approach might be identified in the FSA’s suggestion that consumers
be made aware of the consequence of not reading regulated disclosures: Discussion Paper
No. 08/5, p. 31.
Williams, ‘Empowerment’, 238.
60
designing a retail investor protection regime
measures may represent the path of least resistance (and certainly do in
the context of harmonization) and may distract attention from difficult
supply-side reforms,117 particularly during periods where the retail constituency is politically quiescent118 – usually the status quo for much of
Europe. In these circumstances, and although regulators are unlikely to
yield significant power over the retail markets, the relative attraction of
strategies which place more responsibility on the retail investor, as compared with the relentless difficulties of achieving retail market outcomes
through supply-side intervention, are understandable, if not desirable.
d) The risks of the empowerment model and of ‘marketing
the markets’: retail investors and the financial crisis
The empowerment model makes significant assumptions as to investor
competence which are difficult to reconcile with the evidence on retail
investor decision-making (section I. 3 below). The ‘marketing’ dimension
of the empowerment model is also perilous.119 Market investment entails
significant costs for retail investors which may represent a considerable
misallocation of resources given the costs investors incur in trying to ‘beat
the market’ or in investing in actively managed but under-performing
collective investment schemes (CISs).120 Market investment also carries
significant market or investment risks.
The observation that markets are volatile, often irrational, and can be
inefficient in allocating resources, and that investor welfare may accordingly be prejudiced, is uncontroversial. A well-established literature argues
that markets are inefficient given ‘noise traders’ who trade on the basis of
irrelevant information,121 and a weight of evidence suggests that irrational
117
118
119
120
121
In the 2003 US Congressional session, consumer-related financial services bills, including
a bill to protect home buyers from predatory mortgage practices, failed, but in the same
period a bill establishing the Financial Literacy and Education Commission became law
in less than three months: Willis, Against Financial Literacy, p. 50.
L. Bebchuk and Z. Neeman, Investor Protection and Interest Group Politics (2007), ssrn
abstractid=1030355.
J. Gray, ‘The Sandler Review of Medium and Long-Term Retail Savings in the UK: Dilemmas for Financial Regulation’ (2002) 10 Journal of Financial Regulation and Compliance
385.
K. French, ‘Presidential Address: The Cost of Active Investing’ (2008) 63 Journal of Finance
1537, highlighting that, on average, the US spends 0.79 per cent of the aggregate value of
the US equity market to invest each year and that active investors spend 0.67 per cent of
total market capitalization each year in a ‘futile search for superior returns’ (at 1558–9).
E.g. F. Black, ‘Noise’ (1986) 41 Journal of Finance 529 and J. Bradford De Long, A. Shleifer,
L. Summers and R. Waldmann, ‘Noise Trader Risk in Financial Markets’ (1990) 98 Journal
of Political Economy 703.
why intervene in the retail markets?
61
momentum, herding and irrelevant information can distort prices122 –
vividly illustrated by the dotcom crash and the Enron-era scandals.123
Market risks appear to be entrenching as markets become increasingly
complex.124 The financial crisis has placed further pressure on market
efficiency theories.125 It has also wreaked destruction on household market savings. Equities,126 bond investments,127 investment trusts,128 structured products129 and CISs130 (although by the end of 2008 investors were
122
123
124
125
126
127
128
129
130
E.g. Langevoort, ‘Animal Spirits’.
E.g. L. Ribstein, ‘Market vs Regulatory Responses to Corporate Fraud: A Critique of the
Sarbanes–Oxley Act 2002’ (2002) 28 Journal of Corporation Law 1.
Modern financial management techniques may have led to markets coming to resemble
casinos: L. Mitchell, The Morals of the Marketplace (2008), ssrn abstractid=1129340.
The Turner Review, for example, summarized the challenges to market efficiency as
including that: market efficiency does not imply market rationality; individual rationality
does not ensure collective rationality; individual behaviour is not entirely rational; there
are limits to allocative efficiency benefits; and empirical evidence illustrates large-scale
herd effects and market overshoots: FSA, The Turner Review: A Regulatory Response to the
Global Banking Crisis (2009) (‘Turner Review’), pp. 39–42.
One year after the start of the credit crunch, and before the most dramatic market
plunges, UK private shareholders were estimated to have lost £48 billion: C. Seib, ‘Private
Shareholders Have Lost £48bn on Investments since Credit Crunch Started’, The Times,
25 August 2008, p. 36. The market capitalization of European stock exchanges fell by €5.6
trillion in the twelve months prior to October 2008: Federation of European Securities
Exchanges, Share Ownership Structure in Europe (2008), p. 5, noting ‘the loss of financial
wealth has been massive’. One report has highlighted the drop of more than 60 per cent in
the value of US stocks since 2000 and a ‘broad sense of betrayal among the [US] populace
that the faith all had been told to put in equities had been misplaced’: J. Authers, ‘Is It
Back to the Fifties?’, Financial Times, 25 March 2009, p. 9.
Including where issuers defaulted or delayed (as did Deutsche Bank) on redemption
obligations: P. Davies and J. Wilson, ‘Deutsche Bank Faces Buyer Strike Over Decision Not
to Redeem Bond’, Financial Times, 19 December 2008, p. 15.
Trusts suffered steep share price reductions and a widening of the discount to net asset value
to which they typically trade: S. Johnson, ‘UK Investment Trusts Hit Hardest’, Financial
Times, Fund Management Supplement, 8 December 2008, p. 1.
Major failures included two UK (Legal & General) capital-protected products, linked to
the Lehman bankruptcy: K. Burgess and A. Ross, ‘L&G investors will pay price of Lehman
collapse’, Financial Times, 16 December 2008, p. 17.
Retail investors in the EC fled from CISs in all asset classes in the third quarter of 2007,
moving into cash or high-interest deposit accounts; net redemptions amounted to €61
billion for the quarter ending September 2007, representing 1 per cent of the asset base
of Europe’s fund industry: J. Saft, ‘Banks Benefit as European Investors Flee Financial
Markets’, International Herald Tribune, 17 December 2007, available via www.iht.com.
Matters worsened significantly in 2008. Equity schemes, for example, shrank dramatically,
reducing from €350 billion to €188 billion over 2008, and massive withdrawals took
place in the first and third quarters of 2008: S. Johnson, ‘Hopes of Return to Calmer
Times’, Financial Times, Fund Management Supplement, 5 January 2009, p. 1; and S.
Johnson, ‘UCITS Outflows Soar in Q3’, Financial Times, Fund Management Supplement,
62
designing a retail investor protection regime
returning to more stable money-market schemes131 ) have all been affected.
The massive withdrawals from the European CIS industry alone suggest
the scale of investor losses.132 The Commission has estimated that assets
invested in the most common retail packaged products (CIS, insurance
products and structured products) fell in value from €10 trillion at the
end of 2007 to around €8 trillion at the end of 2008.133
But the empowerment and responsibilization models appear resilient
to major market shocks. Regulators generally regard general market risk
as a burden to be borne by the investor,134 even though this risk deters
engagement,135 and this tendency has persisted over the crisis. It took
some time for the financial crisis to be addressed on the education sites
of major international regulators136 and retail interests have not featured
largely in the international debate.137 In particular, recent UK and EC
policy debates have not engaged closely with retail investor exposure to
general market risk.138 The FSA is, however, notable for its regular highlighting of the risks from market volatility in its annual Financial Risk
131
132
133
134
135
136
137
138
1 December 2008, p. 2. The picture became significantly worse in the final quarter,
reflecting the autumn 2008 market convulsions. Outflows reached €142 billion, making
that quarter the worst in the sector’s history; almost 40 per cent of the year’s outflows
occurred in October, reflecting the massive market instability: European Fund and Asset
Management Association, Quarterly Statistical Release No. 36 (2008), pp. 2 and 5. In the
US, investors withdrew €237 billion from mutual funds in 2008, the biggest ever exodus of
funds from professional management: D. Brewster, ‘Retail Investor Behaviour’, Financial
Times, 25 March 2009, p. 9.
D. Ricketts, ‘Mutual Funds Move Back into the Black’, Financial Times, Fund Management
Supplement, 19 January 2009, p. 11, reporting a ‘cautious return by retail investors’.
Between June 2007 and September 2008, €416 billion was withdrawn from CISs, although
much of this represents institutional investment: Johnson, ‘Hopes of Return’.
Packaged Products Communication, p. 1.
G. Pearson, ‘Risk and the Consumer in Australian Financial Services Reform’ (2006) 28
Sydney Law Review 99.
FSA research has consistently found market risk to be a key inhibitor: for example,
FSA, Accessing Investment Products, Consumer Perceptions of a Simplified Advice Process
(Consumer Research No. 73, 2008), p. 7. Recent research on household reaction to the
‘credit crunch’ has similarly found that low levels of trust in December 2008 (and, as
discussed later in this chapter, disengagement from the markets) were primarily related
to a ‘brutal loss in stock market valuations’: P. Sapienza and L. Zingales, A Trust Crisis
(2009), p. 6.
See further ch. 7.
Although the April 2009 G20 statement makes a vague reference to the effect that regulators and supervisors must protect consumers and investors: London Summit – Leaders’
Statement, 2 April 2009, para. 14.
Retail investor exposure to market risk is absent from the FSA’s RDR (although it might be
argued to be implicit in the Turner Review’s acceptance of the limits of market efficiency)
and, for the most part, from the EC’s recent consideration of retail market policy in its
discussion of substitute products.
why intervene in the retail markets?
63
Outlooks.139 But, and reflecting the empowerment objectives embedded
in FSMA, Outlooks typically associate market volatility with potential
damage to investor confidence, a widening of the savings gap and the
risks of a flight to riskier products.140 The FSA’s identification of market risk accordingly reflects a concern to ensure that investors do not
leave the markets.141 Although the FSA’s 2008 Financial Risk Outlook
noted that the financial crisis might require it to change its consumer
information priorities,142 it was more concerned by the risk of potential
disengagement from financial services.143 The 2009 Risk Outlook similarly highlighted the risk of prejudice to consumer willingness to engage
with financial services and of savings behaviour being embedded which
would be difficult to reverse in more stable conditions.144 Although the
FSA’s 2009–10 Business Plan links the financial crisis to its retail market activities, its focus is on empowerment-related concerns to improve
marketing and strengthen capability as well as on strengthening firms and
embedding the TCF strategy;145 wider reconsideration of how investors
should engage with the market does not, unsurprisingly, feature. The
Commission has been similarly reluctant to address general market risks.
In its 2009 consultation on reform of the Investor Compensation Scheme
Directive, it was still confidently asserting, notwithstanding the destruction of retail investor value, that ‘it has been a mainstay of our approach to
financial regulation that investors in financial investments should not be
protected from investment risk’.146 The April 2009 Packaged Products
139
140
141
142
144
145
146
The 2005 Outlook, for example, warned that weaker equity market performance would
lead to financial losses for some consumers, that volatility in equity and bond prices
would lead to sharp movements in the value of many investment products and that rising
interest rates could lead to significant capital losses for consumers holding bond-related
investment products.
The 2005 Financial Risk Outlook warned of a widening in the savings gap and longterm opportunity losses: Financial Risk Outlook 2005, p. 27. The 2006 Outlook was also
concerned that market volatility could lead to a loss of confidence in financial instruments
and a flight to alternative investments: Financial Risk Outlook 2006, pp. 21 and 23.
E.g. Financial Risk Outlook 2005, pp. 27 and 28 and Financial Risk Outlook 2006, pp. 21–3
and 80.
FSA, Financial Risk Outlook 2008, p. 13. 143 Ibid., pp. 28 and 29.
FSA, Financial Risk Outlook 2009, pp. 68–9. It noted, for example, consumer caution with
respect to equity-based products and the relative popularity of deposit accounts given
their security.
Business Plan 2009–2010, p. 25.
European Commission, Directive 1997/9/EC on Investor Compensation Schemes: Call for
Evidence (2009), p. 8. The related impact assessment suggested that market or investment
risk is ‘the price that needs to be paid to gain the potential for greater performance’: SEC
(2009) 556, p. 6.
64
designing a retail investor protection regime
Communication similarly underlined that regulation could not protect against adverse outcomes given the market risk integral to most
products.147 But it is well time to reconsider the assumption that regulation is powerless to address general market risk. It is based on the
traditional view that regulation is a function of the prevention of fraud
and malfeasance and not a device for protecting retail investors against
macro-economic shocks, and reflects the caveat emptor principle. But the
caveat emptor principle has its roots in a time when widespread engagement with the markets was not promoted and when markets were simpler;
it is now in need of recharacterization.
The empowerment movement also seems to be resilient to what now
appears to be recurring evidence of regulatory failure and of its impact
on investor welfare. The scale of the regulatory failure associated with the
financial crisis is only now emerging. The market mechanisms on which
the regulatory framework relied certainly failed.148 It also appears that preexisting regulation, particularly in the form of the Basel II capital regime
and the fair value/mark-to-market accounting approach, has contributed
by reinforcing procyclicality. Regulators have also failed to address the
macro-prudential risks to overall systemic stability which arise when major
financial institutions act in a similar manner, have overlooked the linkage
between regulation, markets and wider macro-economic policy and do not
appear to have engaged with the risks which arose from the transmission
of debt from the banking system into securities markets.149 They have
also struggled with the burgeoning complexity of markets.150 The risks
to retail investors can be exacerbated as market turbulence can lead to a
diversion of regulatory and supervisory resources from the retail markets
when financial-market architecture and systemic issues become pressing;
this might explain, in part, the very limited response to investor education
and advice needs as markets plunged in the second half of 2008. The
risks are also evident from the FSA’s decision in late 2008 to scale back
147
148
149
150
Packaged Products Communication, p. 5.
E.g. S. Schwarcz, Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown (2008), ssrn abstractid=1056241; and Turner Review, pp. 45–7.
E.g. W. Buiter, Lessons from the 2007 Financial Crisis (CEPR Policy Insight No. 18,
CEPR, 2007); M. Brunnermeier, A. Crocket, C. Goodhart, A. Persaud and H. Shin, The
Fundamental Principles of Financial Regulation. Geneva Reports on the World Economy 11. Preliminary Conference Draft (International Center for Monetary and Banking
Studies (ICMB), 2009) and High-Level Group on Financial Supervision, Report (2009)
(‘de Larosi`ere Report’).
S. Schwarcz, Regulating Complexity in Financial Markets (2009), ssrn abstractid=1240863.
why intervene in the retail markets?
65
its TCF supervisory initiatives,151 which led to considerable concern from
the FSCP.152
Retail investors cannot be insulated from complexity and from regulatory failures which lead to systemic market losses. All the indications
are that the reform process will be wide-ranging, that the assumption
(which drove much of recent wholesale market regulation) that markets are self-correcting and that market discipline can often be more
effective than regulation, is being challenged and that attempts are being
made to protect the financial system against future failures.153 The catastrophic transmission of wholesale market risks into the retail markets
which occurred might be avoided. But the scale of recent events, and the
increasing difficulties posed by market complexity, suggests that another
major regulatory failure154 leading to systemic losses cannot be ruled out.
It may be time therefore to think more closely about how general market
risks can be managed and to recalibrate the empowerment rhetoric and
policy.
General market risk is not easily managed by regulation, not least
because of flawed regulator incentives. Where regulatory power depends
on the championing of widespread participation in the markets, the regulator has few incentives to highlight investment risks, whether explicitly or through tougher regulation, without risking a reduction in retail
investor activity and corresponding damage to its position.155 The world’s
major regulator, the SEC, can be examined as having adopted, through its
massive issuer disclosure regime, a ‘brand’ of securities regulation which
empowers retail investors and promotes market investments.156 But it has
been criticized for trumpeting market efficiency (described as a ‘Noble
Lie’157 ), implicitly marketing direct investments while failing to take into
account poor retail market awareness of the impact of diversification and
151
152
153
154
155
157
J. Hughes, ‘FSA lowers the customer fairness bar’, Financial Times, 13 November 2008.
FSCP, Press Release, 12 November 2008. Although it should be acknowledged that the FSA
proceeded with its massive RDR over this period.
E.g. the Turner Review, which argued that the susceptibility of financial markets to irrational momentum called for regulation to be based on striking a balance between the
benefits of market liquidity and the disadvantages of instability (p. 42).
Schwarcz has suggested that prescriptive regulation will struggle in protecting increasingly
complex markets from failure and that measures are therefore needed to ensure that failure
in one sector does not trigger a failure elsewhere: Schwarcz, Regulating Complexity.
Langevoort, Expectations Gap, p. 6. 156 Langevoort, ‘Animal Spirits’, 173–4.
G. La Blanc and J. Rachlinski, In Praise of Investor Irrationality (2005), ssrn
abstractid=700710, p. 45.
66
designing a retail investor protection regime
transaction costs158 and for adopting a ‘fair and orderly’ markets rhetoric
which does not reflect the unfairness generated by limited financial
resources and financial literacy.159
But better attempts must be made to manage market risk. Regulation
should focus on diversification as a means of mitigating market risk. Leverage controls, which can dull the impact of market volatility, are already
built into the UCITS product160 but the impact of leverage on the design
of other retail products, notably structured, non-UCITS products, could
also be considered. Procyclicality could be addressed more carefully; product design measures, on the lines of the FSA’s product life-cycle and risk
assessment requirements,161 and disclosure reforms, in the form of a prohibition on past performance disclosures,162 while likely to be limited, could
be considered by the EC. Closer attention must be given to guarantees;
more radical product-based strategies might be employed to incentivize
providers to provide guarantees, but at the very least the resilience of disclosure strategies must be tested as must the risk management procedures
which govern the strength of guarantees. Given that EC retail investment
is strongly based on the bond and equity asset classes which proved so
volatile,163 stronger engagement with alternative investments might be
useful,164 even allowing for alternative classes having under-performed
during the crisis and posed liquidity and redemption risks. While the
severe losses sustained by all asset classes over the financial crisis, and the
removal of the buffering effect normally provided by bond investments,165
may not recur, the complexities and speed of financial market innovation,
and the regular exposing of regulatory failures, suggest that future periods
of large-scale, cross-asset instability will recur. As discussed in chapter 3,
alternative investments are being opened to the retail sector. But closer regulatory engagement, not only with respect to product design but also with
respect to the resilience of distribution and advice structures, is required.
158
159
161
163
164
165
Langevoort, Expectations Gap, p. 35; and H. Jackson, ‘To What Extent Should Individual
Investors Rely on the Mechanisms of Market Efficiency: A Preliminary Investigation of
Dispersion in Investor Returns’ (2003) 28 Journal of Corporation Law 671.
Bradley, ‘Disorderly Conduct’. 160 See further ch. 3.
See further ch. 3. 162 See further ch. 5.
40 per cent and 39 per cent of assets under management in the European fund management industry represent bond and equity classes, respectively: EFAMA, Annual Asset
Management Report: Facts and Figures (2008), p. 3.
E.g. A Report Prepared at the Request of the Deputies of the Group of Ten by an Experts’ Group
Chaired by Ignazio Visco, Banca d’Italia, Ageing and Pension System Reform: Implications
for Financial Markets and Economic Policies (2005), p. 34.
EFAMA, Annual Report 2007–2008, pp. 8–9.
why intervene in the retail markets?
67
Particular care must also be taken in designing a regulatory response to
the growth of structured retail products given their potential for delivering
diversified returns and capital protection.
3. The irrational and uninformed investor
a) The irrational and uninformed investor: the evidence
Market risk therefore challenges the empowerment model. So too does
the evidence outlined in chapter 1 of limited investor experience with
investments. Above all, perhaps, so does the emerging evidence on how
investors behave. With its emphasis on autonomy and informed choice,
and its attachment to disclosure and investor education strategies, investor
empowerment is closely associated with the rational behaviour model
espoused by the law and economics, efficiency-driven school of analysis166
which has exerted such a profound influence on research and policy in
law and economics. The empowerment model reflects the assumptions
of law and economics that investors act as self-interested rational agents,
seek to maximize utility and are capable of acquiring and assessing relevant information, and that sporadic divergences from rationality will
be removed by arbitrage mechanisms.167 But, while law and economics
has provided powerful tools for analysis, and in particular for exposing
principal/agent risks,168 it is now clear that rational homo economicus is,
if not extinct, then certainly a very rare character; homo sapiens, with
all her flaws and complexities, is in the ascendant.169 The persistence
nonetheless of homo economicus, in the face of mounting evidence of
irrationality, points to the relative simplicity of rationality as a means of
modelling human behaviour when designing rules170 and to the difficulties
posed by alternative models.171 It might also point to the attractiveness of
166
167
168
169
170
171
E.g. L. Stout, Taking Conscience Seriously (2006), ssrn abstractid=929048; and R. Korobkin,
‘The Endowment Effect and Legal Analysis’ (2003) 97 Northwestern University Law Review
1227.
E.g. Easterbrook and Fischel, ‘Mandatory Disclosure’; and R. Ippolito, ‘Consumer Reaction
to Measures of Poor Quality: Evidence from the Mutual Fund Industry’ (1995) 35 Journal
of Law and Economics 45.
E.g. P. Mahoney, ‘Manager–Investor Conflicts in Mutual Funds’ (2004) 18 Journal of
Economic Perspectives 161.
R. Thaler, ‘From Homo Economicus to Homo Sapiens’ (2000) 14 Journal of Economic
Perspectives 133.
Thaler, ibid. (noting that it is easier to build a model of a rational, unemotional agent);
and Stout, ‘Taking Conscience’.
Arlen, ‘Future of Behavioral Economic Analysis’.
68
designing a retail investor protection regime
the law and economics model for the deregulatory movement which,
until the financial crisis, had been associated with financial market
regulation.
The burgeoning behavioural finance literature and the related
behavioural analysis of securities regulation, which has recently focused
on the retail investor, exposes a different reality. Many households make
financial decisions that are hard to reconcile with the advice they may
receive or with standard finance models.172 A rich legal literature on
investment decision-making has developed,173 drawing on the findings
of behavioural finance,174 which supports a more nuanced model of retail
investor behaviour and regulation. Much of the evidence is concerned
with direct market investments, trading and issuer disclosure, rather than
with the purchase of investment products which strongly characterizes
the EC and UK markets, as outlined in chapter 1. Nonetheless, it suggests
that the investment markets are a challenging environment for a nascent
retail investor constituency and that empowerment-based, investor-facing
strategies generate significant risks.
A considerable weight of evidence, reflecting the early insight that
individuals are only ‘boundedly rational’,175 points to systematic, poor
decision-making.176 This research builds on the seminal work of Kahneman and Tversky on the prevalence of systematic biases and deviations
from rationality in decision-making,177 with the 1980s seeing two of the
172
173
174
175
176
177
J. Campbell, ‘Household Finance’ (2006) 61 Journal of Finance 1553, 1554.
E.g. S. Bainbridge, ‘Mandatory Disclosure: A Behavioral Analysis’ (2000) 68 University
of Cincinnati Law Review 1023; S. Bainbridge, ‘Whither Securities Regulation? Some
Behavioral Observations Regarding Proposals for Its Future’ (2002) 51 Duke Law Journal
1397; Langevoort, ‘Animal Spirits’; L. Stout, ‘The Mechanisms of Market Efficiency: An
Introduction to the New Finance’ (2003) 28 Journal of Corporation Law 635; R. Gilson and
R. Kraakman, ‘The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight
Bias’ (2003) 28 Journal of Corporation Law 215; and E. Augouleas, ‘Reforming Investor
Protection Regulation: The Impact of Cognitive Biases’ in M. Faure and F. Stephen (eds.),
Essays in the Law and Economics of Regulation In Honour of Anthony Ogus (Antwerp:
Intersentia, 2008).
For summaries of the main findings see, for example, Prentice, ‘Whither Securities Regulation’, 1454–89; La Blanc and Rachlinski, In Praise, pp. 17–21; and R. Deaves, C. Dine and
W. Horton, How Are Investment Decisions Made?, Research study prepared for the Task
Force to Modernize Securities Legislation in Canada (2006) (‘Deaves Report’), pp. 252–6.
Developed by Herbert Simon: H. Simon, ‘A Behavioral Model of Rational Choice’ (1955)
69 Quarterly Journal of Economics 99.
Generally, R. Shiller, Irrational Exuberance (Princeton and Oxford: Princeton University
Press, 2000).
E.g. D. Kahneman and A. Tversky, ‘Prospect Theory: An Analysis of Decision under Risk’
(1979) 47 Econometrica 263.
why intervene in the retail markets?
69
early applications of behavioural finance to financial decision-making.178
Since then, a voluminous financial economics and legal literature has
developed on the evidence on and implications of significant and systematic defects in investor decision-making. Rules of thumb are used to ease
complex decisions and lead to poor decision-making.179 The status-quo
bias, which means that decision-makers are reluctant to make changes
and undervalue the risks of the status quo and the benefits of choice,180
leads investors to hold investments for too long181 and to a related tendency not to ‘shop around’. The endowment effect, or the tendency to
demand more to surrender an asset than its acquisition cost,182 leads to
investors assessing risks in terms of loss aversion rather than in terms
of final return.183 Cognitive conservatism also limits the extent to which
investors change their decisions, even in the face of evidence that change
is optimal. The framing effect means that investor vulnerability to marketing is significant; the way in which an investment choice is framed (in
terms of the loss of an investment opportunity, for example) can drive the
investment decision.184 The hindsight bias increases investor vulnerability
to past performance information. The limitations of disclosure are borne
out by the confirmation bias, which leads investors to rely on evidence or
disclosures which reinforce their decisions, and by the availability shortcut,
which leads investors to rely on information which is most easily brought
to mind.185 Biases can also be contrarian. While loss aversion and the
status quo bias suggest conservative decision-making, over-confidence186
is a particularly well-documented bias.187 It leads to investors being overoptimistic as to their skill, discounting the impact of chance (save with
178
179
180
181
182
183
184
185
186
187
H. Shefrin and M. Statman, ‘Explaining Investor Preference for Cash Dividends’ (1984)
13 Journal of Financial Economics 253; and W. de Bondt and R. Thaler, ‘Does the Stock
Market Overreact?’ (1985) 40 Journal of Finance 793.
S. Benartzi and R. Thaler, ‘Naive Diversification Strategies in Defined Contribution Savings
Plans’ (2001) 91 American Economic Review 79.
E.g. Ogus, Regulatory Paternalism, p. 307.
T. Odean, ‘Are Investors Reluctant to Realize Their Losses?’ (1998) 53 Journal of Finance
1775.
Korobkin, ‘The Endowment Effect’.
Arlen, ‘Future of Behavioral Economic Analysis’, 1771.
A. Tversky and D. Kahneman, ‘Rational Choice and the Framing of Decisions’ (1986) 59
Journal of Business 251; and D. Langevoort, ‘Towards a More Effective Risk Disclosure for
Technology-Enhanced Investing’ (1997) 75 Washington University Law Quarterly 753.
C. Sunstein, ‘What’s Available? Social Influences and Behavioral Influences’ (2003) 97
Northwestern University Law Review 1295.
R. Korobkin and T. Ulen, ‘Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics’ (2000) 88 California Law Review 1051.
It has been supported by some hundreds of studies (C. Jolls, ‘Behavioral Economics
Analysis of Redistributive Legal Rules’ (1998) 51 Vanderbilt Law Review 1653) and is
70
designing a retail investor protection regime
respect to losses), over-emphasizing positive returns and underestimating
risk levels.188 Ultimately, poor decision-making based on over-confidence
can lead to a wider misallocation of resources.189 Trend-chasing is also
common, as is herding behaviour.190
As a result, investor decision-making is far from the model of rational, self-interested, utility-maximization assumed by efficiency theory
and implicit in the empowerment model. Decision-making failures make
the direct trading process particularly problematic (chapter 6). But
poor decision-making also relates to choice of investment products191
(chapter 3), particularly with respect to how disclosure is processed
(chapter 5), and is reflected in over-reliance on investment advice
and in investor difficulties in assessing conflicts-of-interest disclosure
(chapters 4 and 5). Choice, strongly associated with investor empowerment, is accordingly something of a siren’s call in the retail markets,192
particularly with respect to investment products.193 Overall, retail investors
simply tend to make bad decisions.194
These findings are increasingly being confirmed by industry studies195
and by regulator-sponsored surveys which point to poor decision-making
188
189
190
191
192
193
194
195
described as ‘the most robust finding in the psychology of judgment’: Langevoort, ‘Animal
Spirits’, 146, citing an ‘oft repeated’ finding from W. de Bondt and R. Thaler, ‘Financial
Decision-Making in Markets and Firms: A Behavioral Perspective on Finance’ (1995) 9
Handbook of Operations Research and Management Science.
Langevoort, ‘Animal Spirits’, 146–7.
La Blanc and Rachlinski, In Praise, pp. 2 and 17.
Shiller, Irrational Exuberance, pp. 157–62.
L. Costanzo and J. Ashton, ‘Product Innovation and Consumer Choice in the UK Financial
Services Industry’ (2006) 14 Journal of Financial Regulation and Compliance 285.
A leading study has found that most participants did not have the skill to pick portfolios
aligned with their attitude to risk and, accordingly, has questioned the presumption that
adding choice makes consumers better off: S. Benartzi and R. Thaler, ‘How Much Is
Investor Autonomy Worth?’ (2002) 57 Journal of Finance 1593.
As has been acknowledged by the FSA, for example in Financial Risk Outlook 2007, p.
10. In the EC context, FIN-USE, the Commission’s representative group on the retail
markets, has repeatedly pointed to the risks of increased choice and investor confusion.
E.g. FIN-USE, Financial Services, Consumers and Small Businesses: A User Perspective on
the Reports on Banking, Asset Management, Securities and Insurance of the Post FSAP Stock
Taking Groups (2004), p. 1 and 4.
‘[M]any do not begin to save till very late and do not save enough once they start. Risk is
not well understood: it is common to believe that an individual security is less risky than a
market index. People become increasingly hesitant and even paralyzed when offered additional asset choices. Ignoring the most basic lessons of diversification, future retirees put
far too much money into company stock, and fall prey to recency and representativeness
in chasing winners’: Deaves Report, pp. 256–7.
E.g. ANZ, Adult Financial Literacy, Personal Debt and Financial Difficulty in Australia
(2005); and NASD, NASD Investor Literacy Research: Executive Summary (2003).
why intervene in the retail markets?
71
as well as limited understanding of the investment process. The 2005
Canadian Deaves study, for example, which characterized evidence on
how investors behave as a ‘needed piece of the puzzle’ when designing regulatory reforms,196 summarized its survey findings as follows: ‘knowledge
levels are often low and decisions are tainted by behavioural bias. Some
are over confident, subject to emotion and chase winners.’197 Investors
displayed over-confidence,198 relied on gut feelings and instinct199 and
relied inappropriately on past performance.200
In the EC, the 2007 BME Report provides (for the first time on a pan-EC
basis) a picture of retail investor capability significantly at odds with the
investor-facing, empowerment model; the Council’s Financial Services
Committee has similarly bleakly identified a ‘currently unsophisticated
and unprepared retail mass market’.201 As outlined in chapter 1, experience
with investments is limited. But diversification is also weak. Household
equity portfolios are generally limited to a small number of shares and
display a strong home bias,202 clear from the evidence from France,203
the Nordic countries204 and Italy.205 There is, however, some evidence of
196
198
199
200
201
202
203
204
205
Deaves Report, p. 250. 197 Ibid., p. 247.
Particularly with respect to their ability to ‘beat the market’: ibid., p. 278.
One-quarter of investors stated that intuition drove investment decisions: ibid.
Ibid., p. 279.
Subgroup on the Implications of Ageing on Financial Markets, Interim Report to the FSC
(FSC4180/06, 2006) (‘FSC Report’), p. 21.
BME Consulting, The EU Market for Consumer Long-Term Retail Savings Vehicles: Comparative Analysis of Products, Market Structure, Costs, Distribution Systems, and Consumer
Savings Patterns (2007) (‘BME Report’), p. 49, reporting that ‘retail equity investments are
almost completely limited to domestic shares’ and that this trend did not change over
1999–2005. More generally, the Commission has reported that EC investors continue to
demonstrate a home bias in equity investments, although it suggested that the bias effect
was declining and that the increase in investments in other Member States (from 52 per
cent to 55 per cent between 2001 and 2005) pointed to the emergence of a regional EU
bias: European Commission, Financial Integration Monitor 2007 (SEC (2007) 1696), p. 9.
French households are generally under-diversified with 80 per cent of shareholders in
privatized companies holding fewer than five stocks and only 26 per cent of equities held
by French households representing foreign issuers: B. S´ejourn´e, Why Is the Behaviour of
French Savers So Inconsistent with Standard Portfolio Theory? (AMF Working Papers, 2006)
(‘French Savers’), pp. 6, 8 and 9.
Less than 10 per cent of Nordic investors hold securities of foreign issuers: Centre for
Strategy and Evaluation Services, Study in the Impact of the Prospectus Regime on EU
Financial Markets (2008) (commissioned by the European Commission) (‘CSES Report’),
p. 18. Although the Swedish market represents one of the important retail stock markets
in the Community in relative terms, household investments are heavily concentrated in
Ericsson and TeliaSonera shares (although diversification is improved by indirect CIS
investment: BME Report, p. 46).
Fifty per cent of Italian shareholders have a portfolio composed of no more than two
shares: ibid., p. 47.
72
designing a retail investor protection regime
retail investor appetite for cross-border investments.206 Bond investments
are similarly locally based; cross-border activity in the debt market is very
limited.207
Exacerbating the home bias, understanding of the process of market
investment is limited, although understanding levels vary.208 Knowledge of
different investments is poor; knowledge concerning bonds is particularly
low in some Member States and knowledge of CISs is variable.209 The
pan-EC 2008 Optem Report on disclosure similarly found low levels of
understanding of terms such as ‘leveraged’ and ‘derivative’ and difficulties
with percentage disclosure.210 Similar findings have been reported by the
Council’s Financial Services Committee which concluded that current
levels of understanding were too low.211
Once investment decisions are made, they tend not to be revisited very
often; investment performance is reviewed only infrequently.212
These findings are mirrored both internationally213 and in national
studies. The FSA has engaged in an extensive series of studies on financial
capability and on attitudes to investment and risk.214 They suggest low levels of understanding and have led to financial capability being persistently
206
207
208
209
210
211
213
214
Retail investors have doubled their holding of equities issued in another Euro-zone Member State to 29 per cent, although the vast majority of portfolios are composed of domestic
shares: ibid., p. 27. In the Netherlands, 15 per cent of private investors invest on foreign
stock markets: AFM, Policy and Priorities, p. 11.
BME Report, p. 26.
Bonds, shares and investment funds are not seen as long-term investments, particularly in
France and the UK, although Poland and Italy show stronger understanding: ibid., p. 194.
Ibid., p. 195.
Optem, Pre-contractual Information for Financial Services: Qualitative Study in the 27
Member States (2008) (‘Optem Report’), p. 108.
FSC Report, p. 21. 212 BME Report, p. 196.
Australian investors, for example, have poor understanding of the risk/return relationship:
ANZ, Adult Financial Literacy, p. 3. An NASD survey of US investors found that only 35
per cent answered at least seven of ten basic market knowledge questions correctly: NASD,
Investor Literacy, pp. 6 and 9. See generally, for example, A. Lusardi and O. Mitchell,
‘Financial Literacy and Retirement Preparedness: Evidence and Implications for Financial
Education’ (2007) 42 Business Economics 35.
Including: studies of risk appetite in annual Financial Risk Outlooks; studies on investor
behaviour (e.g. Consumer Understanding of Financial Risk (Consumer Research No. 33,
2004); Levels of Financial Capability in the UK: Results of a Baseline Survey (Consumer
Research No. 47, 2006); and Consumer Purchasing and Outcomes Survey (Consumer
Research No. 76, 2009)); a series of studies on disclosure (chs. 3 and 5); and a series
of studies on awareness of the FSA and regulation (e.g. FSA, Consumer Awareness of the
FSA and Financial Regulation (Consumer Research No. 67, 2008) and Consumer Awareness
of the FSA and Financial Regulation (Consumer Research No. 62, 2007)).
why intervene in the retail markets?
73
highlighted by the FSA as a risk to the achievement of its objectives.215
Understanding of risk is poor;216 there is considerable misalignment
between investors’ risk appetites and their investment choices.217 Many
investors do not understand which products are linked to the stock market and what is meant by equity;218 in one study, 40 per cent of those
holding an equity-based Individual Savings Account (a structure for holding investments which provides tax benefits) were not aware that its value
fluctuates with stock market performance.219 Investment monitoring is
weak,220 with shares typically being held for eleven years,221 and financial management is reactive rather than proactive.222 ‘Shopping around’
is limited.223 The 2002 Sandler Review earlier described investor choices
of financial product as characterized by an excessive focus on past performance, insufficient attention to asset allocation, a preference for costly
active management and a tendency to use inappropriate timescales over
which to assess performance.224
This troublesome profile repeats across the Member States. The French
TNS-Sofres Report, for example, reported that, while the retail investors
canvassed understood, in principle, the concept of risk, they associated
CISs and equities with lower levels of risk.225 It also found that intuition
plays a major role in share investments, evidence of herding behaviour
215
216
217
218
219
220
221
223
224
225
E.g. Financial Risk Outlook 2007, p. 90.
An earlier study found a deep-seated consumer belief in the long-term performance of the
stock market and that, while risk was accepted on a rational level, it was not personalized:
FSA, Report of the Task Force on Past Performance Information (2001), p. 9.
The 2008 report on awareness of the FSA and regulation, for example, found that 32 per
cent of those holding unit trusts and equity-based products, and 36 per cent of direct share
owners, were not willing to take any risks: FSA, Consumer Research No. 67.
FSA, Towards a Strategy for Financial Capability, p. 6.
FSA, Financial Capability in the UK: Establishing a Baseline (2006), p. 18. Some ISA
investors also erroneously believe that returns are government-guaranteed: FSA, Consumer
Research No. 35, p. 18.
Twenty-two per cent of investors canvassed never monitored their investments: FSA,
Consumer Research No. 47, p. 93. In a subsequent study, the FSA found that only 63
per cent of investors monitored their investments, although 81 per cent recognized that
monitoring was appropriate: FSA, Investment Disclosure Research (Consumer Research
No. 55. 2006), p. 3.
Seib, ‘Private Shareholders’. 222 FSA, Towards a Strategy for Financial Capability, p. 6.
FSA, Losing Interest: How Much Can Consumers Save by Shopping Around for Financial
Products? (Occasional Paper No. 19, 2002); and, more recently, FSA, Consumer Research
No. 76, p. 12.
Sandler Report, pp. 13–14.
TNS-Sofres, Report for the AMF, Investigation of Investment Information and Management
Processes and Analysis of Disclosure Documents for Retail Investors (2006) (‘TNS-Sofres
Report’), p. 8.
74
designing a retail investor protection regime
(particularly in privatizations) and that the ‘thrill of speculation’226 influences investment decisions.227 The Delmas Report highlighted the procyclical tendency of household investments;228 procyclicality and poor
diversification have also been repeatedly highlighted as a risk to households by the French AMF.229 Italian investors also show low levels of understanding of the financial markets and investments.230 Research from the
Netherlands has yielded similar results.231 The Commission’s 2007 Communication on financial education also pointed to low levels of understanding on financial matters more generally.232
b) The implications of the irrational investor
The behavioural finance analysis and the problem of investor irrationality
and limited understanding produces some elegant puzzles concerning the
nature of regulation and, in particular, the dynamics of issuer disclosure,
market efficiency and price formation.233 But the potentially mitigating
effects of the market efficiency mechanisms associated with issuer disclosure are not directly relevant to individual retail investor decision-making.
The policy implications are, therefore, particularly significant in the retail
sphere and with respect to the often intermediated sale of investment
products and individual decision-making.234
One response might be that, far from retail market regulation following an investor-facing empowerment or responsibilization agenda,
226
227
229
230
231
232
233
234
The attractions of speculation have also been identified as a significant driver of the
Taiwanese retail market: B. Barber, Y.-T. Lee, Y.-J. Liu and T. Odean, ‘Just How Much Do
Individual Investors Lose by Trading?’ (2009) 22 Review of Financial Studies 609.
TNS-Sofres Report, p. 37. 228 Delmas Report, Annex V.
E.g. AMF, Risks and Trends Monitoring for Financial Markets and Retail Savings (2008),
p. 65.
L. Enriques, ‘Conflicts of Interest in Investment Services: The Price and Unfair Impact
of MiFID’s Regulatory Framework’ in G. Ferrarini and E. Wymeersch (eds.), Investor
Protection in Europe: Corporate Law Making, the MiFID and Beyond (Oxford: Oxford
University Press, 2006), p. 321, pp. 334–7.
M. van Rooij, A. Lusardi and R. Alessie, Financial Literacy and Stock Market Participation (2007), ssrn abstractid=1014994, showing that households do not understand the
difference between stock and bonds, risk diversification or how financial markets work.
Commission, Financial Literacy.
E.g. Bainbridge, ‘Mandatory Disclosure’ and the articles examining the Efficient Capital
Markets Hypothesis on the twentieth anniversary of Gilson and Kraakman’s seminal
analysis of the mechanisms of market efficiency in (2003) 28 Journal of Corporation Law,
summer issue.
Gilson and Kraakman suggest that behavioural finance, while not convincing in its
attempts to dismantle market efficiency, might justify intervention concerning poor individual decision-making and diversification: ‘Twenty Years Later’, 738–9.
why intervene in the retail markets?
75
restrictive strategies which seek to protect investors from themselves may
be more appropriate, particularly with growing product complexity.235
Retail market intervention might be better concerned with limiting choice or with excluding retail investors,236 whether through
taxation237 or testing238 strategies, than with autonomy, market access and
choice.
It may also be that, in the interests of wider market and regulatory
efficiency, and regarding investors as agents of public policy, retail investor
access to the markets should be controlled given the potential risk of
damage by irrational and disruptive investors.239 Retail investors certainly
have the capacity to influence financial markets.240 Stock market volatility
seems to increase along with wider market participation.241 Mass market
and irrational investing can lead to asset prices drifting from fundamental values242 as arbitrageurs can find it too risky to trade against a tide
of investor sentiment.243 Over-investment and poor resource allocation
235
236
237
238
239
240
241
242
243
T. Hu, ‘Illiteracy and Intervention: Wholesale Derivatives, Retail Mutual Funds, and the
Matter of Asset Class’ (1996) 84 Georgetown Law Journal 2319, 2364.
La Blanc and Rachlinski query whether, if investors make ‘bad choices’, the sensible
response is to stop them from doing so (In Praise, p. 21), while Rachlinski has suggested
that, ‘instead of encouraging cheap access to the markets and information for all investors,
the cognitive error story suggests placing significant restrictions on access to the markets’:
J. Rachlinski, ‘The Uncertain Psychological Case for Paternalism’ (2003) 97 Northwestern
University Law Review 1165, 1185.
E.g. J. Stiglitz, ‘Using Tax Policy to Curb Speculative Short-Term Trading’ (1989) 3 Journal
of Financial Services Research 101; and Stout, asking whether taxation measures or prohibitions could be used to restrict speculative trading: L. Stout, ‘Are Markets Costly Casinos?
Disagreement, Market Failure, and Securities Regulation’ (1995) 81 Virginia Law Review
611.
E.g. S. Choi, ‘Regulating Investors Not Issuers: A Market-Based Proposal’ (2000) 88 California Law Review 279, suggesting that retail investors be restricted to passive investment
funds and that the segmentation of investors be based on some form of investor test.
A ‘driving licence’ model has also been suggested, which would require that investors
show some level of competence before accessing certain products: J. Kozup and J. Hogarth, ‘Financial Literacy, Public Policy and Consumers’ Self Protection – More Questions,
Fewer Answers’ (2008) 42 Journal of Consumer Affairs 127, 134.
On retail investors as a ‘bad influence’, see Bradley, ‘Disorderly Conduct’; Langevoort,
‘Animal Spirits’: and Hu, ‘Illiteracy and Intervention’.
Yen volatility has been related to large volumes of purchases of foreign currency bonds
by Japanese retail investors in an attempt to take advantage of yen appreciation: Bank for
International Settlements, 77th Annual Report 2006–2007, pp. 84–5.
L. Guiso, M. Haliassos and T. Japelli, CEPR Discussion Paper No. 3694, Household Stockholding in Europe: Where Do We Stand and Where Do We Go? (CEPR, 2003), pp. 21–2.
Shiller, ‘Irrational Exuberance’, 203.
A. Shleifer, Inefficient Markets: An Introduction to Behavioural Finance (Oxford: Oxford
University Press, 2000), pp. 28–52.
76
designing a retail investor protection regime
can follow.244 Ultimately, markets may crash as a result of investor irrationality and error.245 Taken to its extreme, this might suggest that retail
investors be either excluded from the markets or somehow restricted,
perhaps through marketing restrictions, to a limited series of regulatorsponsored products.246 At the very least, it might suggest that regulatory
efforts in support of wider participation should be constrained.247 Faint
echoes of this approach have emerged amidst the empowerment rhetoric.
The Delmas Report, for example, noted the risk to the financial system as a whole were poor decision-making and inadequate regulation to
damage the financial system by accentuating the procyclical behaviour of
households.248 The FSA has also expressed concern that wider risks to
market disruption may arise where retail investors, with limited understanding of more complex investment products, withdraw en masse from
particular products, such as illiquid property funds.249 The market disruption argument should not be over-played, however, given limited household involvement250 and the dominance of institutional investors in direct
investments in the Community marketplace. But the fact remains that
the retail investor’s contribution to asset pricing is often contrarian,251
that retail investors act as liquidity suppliers to professional investors who
often trade against the direction of retail trading252 and that they sustain significant losses. Issuers may also benefit from investor irrationality
244
245
246
247
248
249
251
252
P. Mahoney, ‘Is There a Cure for Excessive Trading?’ (1995) 81 Virginia Law Review 713.
F. Partnoy, ‘Why Markets Crash and What Law Can Do About It’ (2001) 61 University of
Pittsburgh Law Review 741.
E.g. La Blanc and Rachlinski, suggesting that collective investment be incentivized and
calling for restrictions on online trading, investor education strategies and marketing
controls: In Praise, p. 3.
This argument was made in the US in the context of Regulation FD and the risk that
‘mindless and erratic price movements’ might follow easier retail investor access to issuer
disclosure: Langevoort, ‘Animal Spirits’, 165.
Delmas Report, p. 12.
Financial Risk Outlook 2008, p. 51. 250 Guiso et al., Household Stockholding, pp. 21–2.
A study on Finnish investor behaviour, for example, has found that domestic investors,
particularly households, pursued contrarian strategies and showed significant negative
performance, cashing in winning stocks and holding losing stocks: M. Grinblatt and
M. Keloharju, ‘The Investment Behaviour and Performance of Various Investor Types:
A Study of Finland’s Unique Data Set’ (2000) 55 Journal of Financial Economics 43. In
the mutual fund context, see A. Frazzini and O. Lamont, ‘Dumb Money: Mutual Fund
Flows and the Cross-Section of Stock Returns’ (2008) Journal of Financial Economics
299.
R. Kaniel, G. Saar and S. Titman, ‘Individual Investor Trading and Stock Return’ (2008)
63 Journal of Finance 273.
why intervene in the retail markets?
77
by exploiting sentiment through equity offerings, stock-financed mergers
and other issuance mechanisms.253
Any attempts to deal with investor irrationality through exclusionary
policies would, however, be highly paternalistic.254 Exclusionary policies
could also damage liquidity255 and asset pricing.256 While it may be sacrificial, widespread market participation has been found to contribute to
asset pricing,257 while retail investor sentiment has been studied given
its impact on pricing and resource allocation.258 Less aggressive strategies which channel retail investors towards particular assets or products,
and which adopt a ‘merit’ approach by requiring the regulator to attest
to their relative ‘safety’ (however this might be captured – perhaps in
terms of returns, protection against market risk and capital protection),
could be canvassed. But merit strategies have become unpopular259 and
the prejudicial implications for innovation and competition are considerable. Intervention of this nature would also significantly increase the
risks of regulatory intervention; market risks may simply be replaced by
regulatory risk. It would also be a long way from the market integration
and choice-supporting principles on which the post-FSAP regime is based,
place considerable strain on the internal market competences on which
the investor protection regime is based and be politically fanciful. There
are echoes of this approach, however, in the segmentation and product
253
254
255
256
257
258
259
Frazzini and Lamont, ‘Dumb Money’.
R. Romano, ‘A Comment on Information Overload, Cognitive Illusion, and Their Implications for Public Policy’ (1986) 59 Southern California Law Review 313, 325.
E.g. Shleifer, Inefficient Markets, pp. 190–4; and Kaniel et al., ‘Individual Investor Trading’, suggesting (at 296) that individual traders are ‘natural liquidity providers’. The liquidity provided by retail investors has, for example, been noted by the London Stock
Exchange in its information on the Alternative Investment Market (AIM): available via
www.londonstockexchange.com.
E.g. La Blanc and Rachlinski, In Praise.
French, ‘Cost of Investing’, 1538, noting that active investors ‘almost certainly’ improve
the accuracy of financial prices.
E.g. Kaniel et al., ‘Individual Investor Trading’, finding that individual trading on the New
York Stock Exchange can, over a short term, predict future returns; and, in the European
context, M. Burghardt, M. Czink and R. Riordan, Retail Investor Sentiment and the Stock
Market (2008), ssrn abstractid=110038. More generally, see M. Baker and J. Wurgler,
Investor Sentiment in the Stock Market (2007), ssrn abstractid=962706.
E.g. H. Pitt, Written Testimony Concerning Accounting and Investor Protection
Issues Raised by Enron and Other Public Companies, Testimony before the Committee on Banking, Housing, and Urban Affairs of the US Senate, available via
www.sec.gov/news/testimony/.
78
designing a retail investor protection regime
regulation techniques currently associated with EC retail market intervention but which, unless carefully executed, risk poor returns for retail
investors and a proliferation of poorly designed products.260
Caution is certainly required in engaging with the behavioural finance
agenda. Behavioural finance remains a shaky basis for radical reforms
without considerably more evidence.261 The range of biases, the lack of a
consistent underlying theory,262 uncertainty as to the extent to which biases
impact on the market, the importance of context in decision-making263
and the troublesome policy loop – if biases exist, how can they be corrected given bias in policy-makers and regulators?264 – all call for care.265
Biases, rather than representing irrationality, have been described in terms
of an evolutionary model, and as being consistent with individuals’ efforts
to adapt to their environment, and to learn from their mistakes, using
short-cuts.266 Other factors, including poor incentive alignment in the
firm/investor relationship, may drive seemingly irrational decisions.267 In
the absence of large-scale evidence on how different types of investors
behave under different conditions and with different asset classes, retail
investors might prejudicially be regarded as a homogeneous group. The
rationality model remains useful for identifying the particular choices
which would maximize wealth and for informing investor education.268
Biases may be dulled by investor learning269 and minimized by advice.270
260
261
262
263
264
265
266
268
269
270
See further ch. 3.
Camerer et al., ‘Asymmetric Paternalism’, 1214; and Arlen, ‘Future of Behavioral Economic
Analysis’, cautioning that behavioural finance ‘cannot provide a coherent alternative model
of human behaviour capable of generating testable predictions and policy conclusions in
a wide range of areas’ (at 1777) and warning that rational choice remains a reasonable
description of individual choice as individuals learn (at 1768).
For an attempt at a unifying theory (from a financial economics perspective), see H. Hong
and J. Stein, ‘A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets’ (1999) 54 Journal of Finance 2143. One of the most high-profile
efforts concerns the evolutionary theory developed by Lo: for example, A. Lo, Reconciling
Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis (2005), ssrn
abstractid=728864.
E.g. Korobkin, ‘The Endowment Effect’, considering how context impacts on the endowment effect and the implications for policy recommendations.
Bainbridge, ‘Mandatory Disclosure’.
S. Choi and A. Pritchard, ‘Behavioral Economics and the SEC’ (2003) 56 Stanford Law
Review 1.
Lo, Adaptive Markets. 267 Mahoney, ‘Manager-Investor’.
Campbell, ‘Household Finance’, 1554.
Arlen, ‘Future of Behavioral Economic Analysis’, 1769.
E.g. Romano, ‘Information Overload’, 326.
why intervene in the retail markets?
79
Market efficiency and competition dynamics are such that it is not necessary that all investors are rational at all times.271 Institutional investors
are active in the European retail CIS products market,272 for example,
and can exert discipline on CISs, particularly with respect to costs.273 It
might also be suggested that irrational behaviour is simply the outcome
of a market failure and a reasonable response by the investor to a lack of
information and/or the costs of becoming informed;274 disclosure reforms
might, accordingly, address the failure.
On the other hand, the empirical evidence is burgeoning, investor learning opportunities are limited as retail investors tend not to be repeat players, advisers can be of doubtful effectiveness275 and the real difficulties
generated by retail market irrationality are at the level of the individual
decision;276 market efficiency, competition and institutional investor discipline are of little support in the mis-selling context or where the retail
investor does not appreciate the costs and diversification effects which can
prejudice returns even where a security’s price reflects efficient market
dynamics. Disclosure’s ability to manage irrationality risks is doubtful;
mounting empirical evidence points to its limitations in improving retail
investor decision-making (chapter 5). There is also little direct evidence
that financial capability strategies can substantially improve decisionmaking as poor financial capability appears to be related more to psychological factors than to a lack of information.277
At the very least, the evidence of irrationality and related evidence
on poor understanding gives investor-protection arguments an overdue
degree of scholarly respectability and the empirical heft which is essential given the policy concern to empower and/or responsibilize the retail
sector. Capital-raising, and the related efficiency school of analysis, has
(arguably for too long) traditionally been the main concern of securities
regulation scholarship.278 Behavioural finance, however, which is often
271
272
273
274
275
277
278
Ibid., pointing to the protection provided by efficiency dynamics; and Choi, ‘Regulating
Issuers Not Investors’, arguing that market efficiency dynamics can compensate for a lack
of knowledge.
EFAMA, Annual Asset Management Report: Facts and Figures (2008), pp. 16–17.
E.g. J. Coates and R. Hubbard, ‘Competition in the Mutual Fund Industry: Evidence and
Implications for Policy’ (2007) 33 Journal of Corporation Law 151.
E.g. U. Malmendier and D. Shanthikumar, ‘Are Small Investors Naive about Incentives?’
(2007) 85 Journal of Financial Economics 457.
See further ch. 4. 276 Gilson and Kraakman, ‘Twenty Years Later’, 742.
FSA, Report by D. De Meza, B. Irlenbusch and D. Reyniers, Financial Capability: A
Behavioural Economists’ Perspective (Consumer Research No. 69, 2008).
Although this argument perhaps is best confined to US securities scholarship (e.g. J.
O’Hare, Retail Investor Remedies under Rule 10b-5 (2007), ssrn abstractid=1019295,
80
designing a retail investor protection regime
associated with regulatory intervention,279 has invigorated the regulation/deregulation debate, challenging law and economics’ traditional hostility to restrictions on autonomy, trumping market dynamics with institutional/supervisory decision-making280 and generating an important
debate on the nature of the appropriate regulatory response. The ‘libertarian paternalism’ model,281 for example, preserves freedom of choice. But
it assumes that individuals can be influenced to make choices which reflect
those which would have been made had individuals complete information,
unlimited cognitive abilities and no lack of will power.282 It supports individuals being steered in directions which promote their welfare, typically
by opt-out options from default opt-in choices.283 In the investor protection sphere, it might be associated with a closer focus on product regulation
and on the difficult question of how the industry can be incentivized to
design products which meet investor needs (chapter 3). Alternatively, a less
interventionist approach to irrationality emphasizes freedom of choice,
focuses on effective decision-making, suggests that individuals be educated
to recognize and deal with irrationality284 and has strong resonances with
disclosure and investor education (chapters 5 and 7). So too has ‘asymmetric paternalism’ which suggests that intervention should be designed
so that it creates large benefits for those who make decision-making errors
but imposes little or no harm on those who are fully rational.285 But disclosure imposes costs and requires sophisticated regulatory technology
(chapter 5). Effective decision-making has, however, also been regularly
associated with the delegation of decision-making to experts.286 Reforms
might therefore focus on the quality of advice and product distribution287
279
280
281
284
285
286
287
pp. 37–8, highlighting the limited attention retail direct investors have received in US
scholarship). UK scholarship has been sensitive to the consumer protection aspects of
financial market regulation (e.g. Gray and Hamilton, Implementing Financial Regulation).
Langevoort, ‘Animal Spirits’, 187.
Rachlinski, ‘Uncertain Psychological Case’, 1165–6 and 1175, suggesting that those inclined
to distrust law and economics and inclined to favour institutional mechanisms have found
in behavioural finance an ‘appealing source of support’.
Thaler and Sunstein, ‘Libertarian Paternalism’. 282 Ibid. 283 Ibid.
G. Mitchell, ‘Libertarian Paternalism Is an Oxymoron’ (2005) 99 Northwestern University
Law Review 1245, 1258 and 1261, highlighting the importance of ‘inoculating’ individuals
against irrational influences.
Camerer et al., ‘Asymmetric Paternalism’, 1233.
E.g. Romano, ‘Information Overload’, 326; and Rachlinski, ‘Uncertain Psychological Case’,
1168.
Thaler and Sunstein suggest that individuals benefit from being required to make their
choices explicit (Thaler and Sunstein, ‘Libertarian Paternalism’, 178), while Mitchell has
argued that requiring individuals to give reasons for their choices can reduce the influence
of framing effects (Mitchell, ‘Oxymoron’, 1256).
why intervene in the retail markets?
81
or even require that advice be taken288 (an assumption implicit in the
restrictions placed on execution-only advice under MiFID), although
the severe conflict-of-interest risks in the advice process calls for caution
(chapter 4).
The three main regulatory levers for the retail market – design, distribution and disclosure – could therefore all be employed to address
the challenges irrationality poses to the empowerment model. But the
evidence of irrationality and poor understanding still sits uncomfortably
with empowerment, responsibilization-based strategies and the concern to
promote the markets. The next section suggests that investor vulnerability
and poor decision-making is better characterized in terms of the vulnerable but engaged ‘trusting investor’, rather than in terms of the irrational
investor. It suggests that a regime which reflects the vulnerabilities of the
engaged but trusting investor, particularly through supply-side reforms,
and which allows that investor to become empowered, while accommodating and supporting the robust, informed and empowered investor, might
represent the best way forward.
4. The trusting investor
a) The trusting investor
The financial crisis convulsions should not obscure the reality that imaginative intervention which strengthens investor decision-making while
acknowledging investor vulnerability, which facilitates investment while
addressing market risk and which engages robustly with the supply side as
well as with the demand side, remains necessary. Governments are withdrawing from welfare provision, retirement needs are acute and the need
for long-term market-based savings is intensifying, not least as interest
rates remain historically low and even if this is a temporary phenomenon.
Stronger financial independence can yield society-wide benefits.289 Households’ tendency not to participate in the stock markets has generated an
extensive financial economics literature290 on the ‘non-participation’ or
stock-holding puzzle.291 It considers why households forego potentially
288
290
291
Rachlinski, ‘Uncertain Psychological Case’, 1224. 289 Deaves Report, p. 309.
E.g. L. Guiso, P. Sapienza and L. Zingales, Household Portfolios (Cambridge: Cambridge
University Press, 2001); and M. Haliassos and C. Bertaut, ‘Why Do So Few Hold Stocks?’
(1995) The Economic Journal 1110.
E.g. Rooij et al., Financial Literacy; L. Guiso and T. Japelli, ‘Awareness and Stock Market Participation’ (2005) 9 Review of Financial Studies 537; and French Savers, noting
‘surprisingly low’ rates of ownership of risky securities in France, far beyond standard
risk-aversion levels (at p. 3).
82
designing a retail investor protection regime
higher stock market returns292 and the associated equity premium293 and
why they risk poor asset allocation in not diversifying beyond deposit and
insurance instruments.294 The welfare loss can be sizeable;295 one study
has calculated it as between 1.5 per cent and 2 per cent of consumption.296
The annual return shortfall from retail investor trading, reflecting limited knowledge of the trading process and poor diversification, is also
potentially significant.297 So too are the potential losses to households
where risk aversion levels increase significantly in the wake of market
turbulence.298 While market and regulatory risks are real, nonparticipation is also a problem.
Investors may also not always be as irrational or as financially illiterate
as usually assumed.299 There is some evidence that the retail investor home
bias might reflect investors’ exploitation of local knowledge300 and that
retail investors seek301 and achieve better diversification.302 Research on
whether investors’ choice of CISs exhibits a ‘smart money’ effect, in that
292
293
294
296
297
298
299
300
301
302
The Council’s Financial Services Committee has highlighted that ‘investment in riskier
assets’ may reduce the pressure on additional savings to cover welfare provision: FSC
Report, p. 11.
P. Shum and M. Faig, ‘What Explains Household Stock Holdings’ (2006) 30 Journal of
Banking and Finance 2579.
AMF, Risks and Trends 2008 Report, p. 83. 295 Rooij et al., Financial Literacy.
J. Cocco, F. Gomes and P. Maenhout, ‘Consumption and Portfolio Choice over the LifeCycle’ (2005) 18 Review of Financial Studies 491. A Federal Reserve study has pointed to
the economy-wide effects, with consumption increased by 5–15 per cent per dollar of
stock market capital gain: K. Dynan and D. Maki, Does Stock Market Wealth Matter for
Consumption? (2001), ssrn abstractid=270190.
One study has suggested an annual return shortfall of 2–2.3 per cent which, over a 20-year
savings horizon, is significant: Barber et al., ‘Just how Much’.
As appears to have happened with UK investors as the financial crisis intensified. The
proportion of respondents willing to take risks with their investments fell from 61 per cent
in 2007 to 56 per cent in 2008 (FSA, Consumer Research No. 67, p. 22) and they became
more cautious concerning equity-based products (Financial Risk Outlook 2009, p. 60).
A. Jackson, The Aggregate Behaviour of Individual Investors (2003), ssrn abstractid=536942;
and J. Coval, D. Hirshleifer and T. Shumway, Can Individual Investors Beat the Market?
(2005), ssrn abstractid=364000.
Z. Ivkovich and S. Weisbenner, ‘Local Does as Local Is: Information Content of the
Geography of Individual Investors’ Common Stock Investments’ (2005) 60 Journal of
Finance 267.
Increasing retail demand for alternative investments has been linked to a desire to diversify
and for stronger returns: PricewaterhouseCoopers, The Retailisation of Non-Harmonised
Investment Funds in the European Union (2008) (‘2008 PwC Retailization Report’), p. 23.
L. Calvet, J. Campbell and P. Sodini, Fight or Flight? Portfolio Rebalancing by Individual
Investors (2007), ssrn abstractid=971062; and L. Calvet, J. Campbell and P. Sodini, Down
or Out: Assessing the Welfare Costs of Household Investment Mistakes, NBER Working Paper
12030 (NBER, 2006) (drawing on evidence from the Swedish stock market).
why intervene in the retail markets?
83
investors choose schemes which subsequently perform well, is inconclusive; but it provides some evidence of effective decision-making.303 Retail
investors also seem to learn from experience,304 as suggested by retail
market reaction to the turn-of-the-century equity market downturn,305
although learning typically follows significant losses. Amidst the stark evidence of household losses, there is also some evidence of shrewd retail
investment over the financial crisis,306 including retail investor recourse to
capital-protected products.307 ASIC’s initial examinations of retail market
trading, for example, did not find uniquely high levels of volatility and, in
January 2008, found an even distribution of buy and sell orders.308
Ultimately, and however uncomfortable a reality it may be given poor
investor decision-making and the bleak evidence of market turbulence,
governments are imposing more financial responsibility on individuals.
303
304
305
306
307
308
A recent study of ‘smart money’ in the UK market, which also reconsiders the contrary US
evidence, suggests that individual (and institutional) investors in actively managed funds
display ‘smart money’ effects: K. Aneel and D. Stoli, ‘Which Money Is Smart? Mutual Fund
Buys and Sells of Individual Investors’ (2008) 63 Journal of Finance 85.
The more products consumers buy, the better they become at exercising choice: FSA,
Establishing a Baseline, p. 18. The FSA has also reported improvements in sensitivity to
disclosure, in that investors were able to differentiate between the Total Expense Ratio
(TER) recommended under the UCITS regime (which does not include entry or exit
charges), and the additional Reduction in Yield (RIY) criteria used by the FSA which
shows the effect of total charges on returns: FSA, UCITS: Charges Disclosure – Presenting
Changes to Customers (Consumer Research No. 34, 2005). A US study has similarly found
that investors learned, over time, to assess front-loaded mutual fund fees, although they
were slower to realize the impact of ongoing expense-related fees: B. Barber and T. Odean,
‘Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows’ (2005) 78
Journal of Business 2095.
The FSA, for example, pointed to greater diversification by retail investors into bonds
following the dotcom-era equity market crash: Financial Risk Outlook 2006, p. 50.
Retail investors began to get nervous about an economic downturn in 2006, selling cyclical
stocks and leading one commentator to suggest that ‘far too often private investors are
derided for simply following market trends. Time and again our research shows this isn’t
true’: Seib, ‘Private Shareholders’. As the credit crunch effects intensified, particularly
in late summer/autumn 2008, UK retail investors were described as holding their nerve
and not offloading equities: R. Wachman and T. Webb, ‘Week of Utter Carnage Moves
the Crunch into the Real World’, The Observer, 12 October 2008, Business, p. 4. Retail
investors also appear to have been alert to liquidity risks, deferring investments in CISs: D.
Ricketts, ‘Mutual Funds Move Back into the Black’, Financial Times, Fund Management
Supplement, 19 January 2009, p. 11. Significant losses were, of course, sustained by the
significant volume of investors who off-loaded CIS investments in the last quarter of
2008.
See further ch. 3.
A. Erskine, ‘Retail Investors – Who Are They? What Do They Invest in?’, ASIC Summer
School July 2008 Papers, p. 7, p. 8.
84
designing a retail investor protection regime
In these circumstances, it is an abdication of responsibility to despair of
the retail markets or to suggest exclusionary measures. The empowerment
model is not misguided in attempting to support stronger market engagement. Empowerment-related and investor-facing disclosure and capability strategies should also not be dismissed. As discussed in chapters 5
and 7, they may reduce the risks of regulatory intervention and lead to
more effective retail investor monitoring. But they have a long horizon.
They do not respond well to retail market risks in the short term. The
empowerment model also does not engage sufficiently closely with poor
decision-making and the reality that the retail investor will often be a
‘novice investor’ and significantly vulnerable to decision-making errors
as well as to market risk.309 Adding the vulnerable, often irrational, but,
importantly, engaged ‘trusting investor’ into regulatory design, however,
may bring better balance, particularly as it implies a focus on imaginative
supply-side measures, and may provide an appropriate rationale for more
robust intervention which, unlike the irrationality model, also engages
well with the empowerment agenda.
The effect of trust310 and of social capital more widely311 on economic
transactions has become the subject of a burgeoning312 scholarship313
and prompted attempts to quantify the impact of trust, including the
309
310
311
312
313
E.g. Campbell, ‘Household Finance’, 1591, warning of the greater likelihood of mistakes by
households when they are asked to take on more financial planning responsibilities; and
J. Kozup, E. Howlett and M. Pagano, ‘The Effects of Summary Information on Consumer
Perceptions of Mutual Fund Characteristics’ (2008) 42 Journal of Consumer Affairs 37,
warning of the risks welfare privatization holds for the novice investor.
Definitions of trust include ‘the expectation that a person (or institution) will perform
actions that are beneficial or at least not detrimental to others’: Chicago Booth/Kellogg
School Financial Trust Index.
Or the ‘shared habits, values and trusting relationships that unite a society’: Kellogg Insight,
Focus on Research, Measuring Trust: Introducing the Financial Trust Index (2009). Trust has
also been defined as the subjective probability individuals attribute to the possibility of
being cheated: L. Guiso, P. Sapienza and L. Zingales, Trusting the Stock Market (2007), ssrn
abstractid=811545. The nature of trust is contested, with different models being used in
the social science and financial economics spheres: C. Mayer, ‘Trust in Financial Markets’
(2008) 14 European Financial Management 617.
One study has suggested that more than 7,000 studies have assessed the economic
effects of trust: P. Sapienza, A. Toldra and L Zingales, Understanding Trust (2007), ssrn
abstractid=1008943.
E.g.: finding a relationship between trust and higher economic performance, S. Knack
and P. Keefer, ‘Does Social Capital Have an Economic Pay-Off? A Cross-Country Investigation’ (1997) 112 Quarterly Journal of Economics 1251; and S. Knack and P. Zak,
‘Trust and Growth’ (2001) 111 Economic Journal 295; finding a relationship between
the early development of securities markets and informal relations of trust, Mayer,
why intervene in the retail markets?
85
Chicago Booth/Kellogg School ‘Financial Trust Index’.314 Trust has been
identified as a key driver of financing and investment315 and a lack of
trust has been associated with the intensifying of the ‘credit crunch’.316
The retail investor fits well with this analysis; faith is required of illinformed and vulnerable retail investors in entrusting funds to markets
and intermediaries.317
Trust is increasingly regarded as a determinant of retail investor
activity.318 Lack of trust in financial markets has been identified as among
the causes of household failure to participate in the financial markets.319
Guiso, Sapienza and Zingales have suggested that ‘trusting individuals’,
who are prepared to make an ‘act of faith’320 that disclosure is reliable and
that the system is fair, are significantly more likely to buy stocks and risk
assets and to invest a large share of household wealth.321 But the study
314
315
316
317
318
319
320
321
‘Trust in Financial Markets’; in the financial markets context, L. Bottazzini, M. da Rin
and T. Hellman, The Importance of Trust for Investment: Evidence from Venture Capital (2007), ssrn abstractid=997934; and, in the corporate law context, M. Blair and L.
Stout, Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law (2000),
ssrn abstractid=241403.
Based on household survey evidence, it measures investors’ trust in stock markets, banks,
mutual funds and large corporations on a quarterly basis.
On the other drivers, see sect. III.3 below.
‘Without trust, co-operation breaks down, financing breaks down and investment stops’:
Sapienza and Zingales, Trust Crisis, commenting on the Financial Trust Index findings from
December 2008. More generally, the April G20 meeting also highlighted the importance of
strengthening financial regulation to rebuild trust: London Summit – Leaders’ Statement,
2 April 2009, paras. 4 and 13.
E.g. Stout, ‘Investor Confidence Game’.
And has been emphasized by the slowly emerging retail constituency in the EC in CESR
discussions: CESR, Annual Report 2005, p. 37.
E.g. Campbell, ‘Household Finance’, 1569; S. Tanner, The Role of Information in Savings
Decisions, Briefing Note 7 (London: Institute for Fiscal Studies, 2000) (arguing that trust is
a determinant of stronger long-term saving); and Deaves Report, pp. 265–6. Trust was also
highlighted as a determinant of investor behaviour by the BME Report (p. 48). Similarly,
the FSA has frequently identified a lack of trust as a barrier to retail market engagement
(e.g. FSA, Treating Customers Fairly – Progress and Next Steps (2004), p. 8, FSA, Consumer
Research No. 35, p. 21 and Financial Risk Outlook 2009, p. 68, noting that the financial
crisis has damaged trust in financial services).
In an earlier study, which pointed to the relationship between levels of trust in Italy and
stock market versus cash holdings, the authors suggested that ‘financial contracts are the
ultimate “trust-intensive” contracts’: L. Guiso, P. Sapienza and L. Zingales, ‘The Role
of Social Capital in Financial Development’ (2004) 94 American Economic Review 526,
527.
Guiso et al., Trusting the Stock Market. The study was based on an examination of Dutch
households under the Dutch National Bank Household Survey.
86
designing a retail investor protection regime
found that, where an investor believes there is a 3 per cent probability of
being cheated, the threshold level of wealth beyond which stock market
investments are made increases five-fold. The study related stock market
participation to levels of trust in the fairness of the ‘rules of the game’,
and warned that, if trust is sufficiently low, very few will participate in
markets. Similarly, Sapienza and Zingales have related withdrawal from
the market over the ‘credit crunch’ to levels of trust; those who planned to
withdraw from the stock markets in December 2008 had the lowest levels
of trust. Higher levels of trust were reported among those prepared to leave
investments unchanged. The highest trust levels were found among those
who planned to increase investments.322 Low levels of trust can also exaggerate the deterrent effect of the costs of participation.323 Once trust has
been damaged, it is not easily reclaimed, further inhibiting retail market
participation.324
More defensively, and reflecting the vulnerabilities of the retail investor,
the retail investor resonances are also strong in that trust, rather than rational reliance, has been identified as the basis of the investor/investment
adviser relationship,325 as is underlined by the repeated reforms to the
UK advice and distribution sector, discussed in chapter 4. The polarization system (which was reformed in 2005) was designed, in part, to
support independent investment advice by ‘polarizing’ the investment
advice and product distribution system into tied agents and independent advisers. But investors remained reluctant to choose independent
investment advisers and chose familiar and trusted tied advisers over
unknown independent advisers.326 Investor trust in market actors is common, notwithstanding conflicts of interest; investors tend, for example,
322
323
324
325
326
Sapienza and Zingales, Trust Crisis, p. 2.
The existence of trust has been associated with some alleviation of the deterrent effect of
investment costs. M. Mayer, ‘Comments on Lynn Stout’s The Investor Confidence Game’
(2002–3) 68 Brooklyn Law Review 449.
The late 1980s/early 1990s personal pension mis-selling saga in the UK cast a long shadow,
with approximately 15 per cent of surveyed consumers still distrusting their advisers in
2005: Basel Committee on Banking Supervision, International Organization of Securities
Commissions, International Association of Insurance Supervisors, Customer Suitability
in the Retail Sale of Financial Products and Services (Bank for International Settlements,
2008) (‘Joint Forum Report’), p. 77.
Rand Institute for Civil Justice, Report on Investor and Industry Perspectives on Investment
Advisers and Broker-Dealers: Sponsored by the SEC (2008) and Langevoort, ‘Selling Hope’.
See also ch. 4, n. 16, on levels of trust in advisers in the EC and the UK.
FSA, Reforming Polarisation – Making the Market Work for Consumers (Consultation Paper
No. 121, 2002), p. 4.
why intervene in the retail markets?
87
to follow the ‘buy’ recommendations of research analysts.327 There is also
some evidence of trust in compliance,328 although entrenched conflictof-interest risks suggests that this trust might be misplaced. Trust has
also been associated with retail investors of limited sophistication;329
the pan-EC Optem Report found that ‘prudent savers’, who, unlike
‘gamblers’, were inclined to rely on investment advice, were driven by
trust when seeking advice.330 What might be termed the irrational tendency of investors to trust the markets chimes well with the evidence
on irrationality and investor behaviour. But the assumption that trusting
investors, while vulnerable and often irrational, also engage with the markets responds more effectively than the irrational investor model to the
need for household market engagement.
What are the implications of the trust analysis for investor protection
policy? There are resonances between investor trust, engagement and regulation. Retail investor trust appears to be related in part to regulation;331
the US Financial Trust Index suggests a relationship between regulation,
trust and engagement.332 The need to support trust and engagement,
but also to reflect the risks of investor trust, through law is also gathering support.333 In a leading analysis, Professor Stout has proposed that
regulation should reflect the needs of the trusting investor; regulation
must acknowledge that retail investors neither expect market participants
to defraud them nor have the resources or inclination to monitor.334
Protecting trust, and ensuring that trust is not abused, suggests, in particular, that robust supply-side intervention is necessary. While investors
may trust intermediaries, they are not in a position to monitor whether
327
328
329
330
331
332
333
334
E.g. Malmendier and Shanthikumar, ‘Small Investors’.
The FSA has reported that 67 per cent of consumers were very or fairly confident that
firms complied with their regulatory obligations: FSA, Consumer Research No. 67.
FSA research has identified ‘trusters’ as consumers with low levels of financial sophistication and high dependence on advisers: FSA, Consumer Understanding of Financial Risk
(Consumer Research No. 33, 2004), p. 2.
Optem Report, p. 88.
B. Carlin, F. Dorobantu and S. Viswanathan, Public Trust, the Law, and Financial Investment
(2007), ssrn abstractid=1033102, suggesting that intervention can improve public trust.
Sapienza and Zingales, Trust Crisis, finding the lowest levels of trust among those who
thought the crisis was due to a lack of oversight and regulation: p. 2.
E.g. L. Zingales, The Future of Securities Regulation (2009), ssrn abstractid=1319648;
P. Huang, How Do Securities Laws Influence Affect, Happiness and Trust? (2008), ssrn
abstractid=1082590; Stout, ‘Investor Confidence Game’; and A. Pritchard, ‘Self Regulation
and Securities Markets’ (2003) Regulation 32.
Stout, ‘Investor Confidence Game’.
88
designing a retail investor protection regime
that trust is warranted. But intervention is necessary not simply to protect
vulnerable investors from abuse; it is also necessary because a failure of
trust may lead to investors leaving the market. Regulatory support of trust
through supply-side reforms therefore also chimes well with the empowerment agenda335 as well as with the need to protect vulnerable and often
irrational investors.
As discussed in subsequent chapters, the sharpening focus on robust
supply-side reforms in the EC regime, but also in UK implementation
‘in action’, points to a policy awareness of the need to bolster investorfacing, empowerment-based measures with more robust strategies if market engagement is to be safely promoted. A warning as to the need for
supply-side regulatory efforts to support the vulnerable but engaged trusting investor might therefore seem otiose. It may seem all the more so given
the regulatory power associated with supply-side intervention, the current hostility to deregulation, self-regulation or lighter-touch regulation
engendered by the financial crisis, and, in the EC context, the Commission’s traditional enthusiasm for regulatory solutions. But supply-side
reforms are difficult. Industry enthusiasm for placing more responsibility on investors is considerable.336 Retail investor involvement in lawmaking and policy formation is limited. There is also intense resource
pressure on regulators concerning the banking system and wholesale markets. All this may create the conditions within which too much responsibility is placed on investors or, less malignly but no less prejudicially,
not enough attention is given to the hard work of supporting vulnerable but engaged trusting investors with imaginative supply-side strategies
‘in action’.
335
336
E.g. ‘[we are] working to secure the trust in our markets that undergirds our nation’s
continuing prosperity’ (SEC, 2007 Performance and Accountability Report, p. 2). The 2004
UK Parliamentary Review into long-term savings similarly suggested that, while there was
no clear definition of the ‘right’ degree of consumer protection, a regulatory framework
that left consumers distrustful of the industry might be considered as failing to meet its
core objectives: Select Committee on Treasury, Eighth Report, Restoring Confidence in Long
Term Savings (2004), sect. 8, para. 75.
E.g. Joint Associations Committee (representing a group of trade associations), Retail
Structured Products: Principles for Managing the Distributor–Individual Investor Relationship (2008). The FSA’s consultation on its guidance for product provider/distributor
responsibilities also saw some sections of the industry question why the FSA had not considered consumers’ responsibilities (FSA, The Responsibilities of Providers and Distributors
for the Fair Treatment of Customers (Policy Statement No. 07/11 (2007), p. 6), while the
FSA’s consumer responsibility paper noted the belief in some quarters that responsibilities
should be imposed on consumers: Discussion Paper No. 08/5, p. 5.
why intervene in the retail markets?
89
b) Blending empowerment-based and trust-based strategies
As discussed in subsequent chapters, the empowered investor and the
trusting investor can both be identified in current EC policy and regulation
and in UK implementation ‘in action’; concerns to fine-tune supply-side
regulation are growing and the attractions of disclosure, while persistent,
are waning.
The FSA has linked empowerment to supply-side as well as to investorfacing initiatives, acknowledged the limitations of empowerment-based,
investor-facing strategies337 and engaged with the importance of trust.338
The FSA’s support of empowerment-based disclosure and financial capability initiatives is designed to equip investors to navigate the markets. But
its muscular supply-side measures,339 particularly under the TCF initiative
(chapters 3 (products) and 4 (advice)) and the RDR (chapter 4), expressly
engage with investor trust340 and acknowledge that empowered investors
also need supply-side support.
The trusting investor, engaged with the markets but suffering from poor
decision-making and vulnerable, can also be traced through current EC
law and policy and is increasingly appearing in the policy rhetoric.341 As
discussed in chapter 4, interventionist distribution-related rules, rather
than empowerment-related disclosure rules, are in the ascendant;342
MiFID favours firm-facing, fiduciary-style obligations over disclosure. The
Commission has rejected suggestions that disclosure requirements, which
remain an important element of the regulatory regime, are based on a
337
338
339
340
341
342
E.g. FSA chairman Lord Turner, Speech on ‘Helping Consumers Through the Recession’,
15 July 2009, available via www.fsa.gov.uk/Library/Communications/Speeches/index.
shtml.
E.g. Financial Risk Outlook 2007, p. 96.
The 2009–2010 Business Plan is based on empowerment-related capability strategies (it
identified consumer capability and responsibility as essential to consumers achieving a fair
deal) but also on firms being well governed and meeting TCF obligations: FSA, 2009–2010
Business Plan, p. 25.
The 2007 RDR, for example, argued that regulation should support market efforts to
generate greater trust (p. 6). Similarly, the FSA’s emerging consumer responsibility strategy
is based on encouraging consumers to act in their best interests but acknowledges the
primary role played by firm regulation.
ESC discussions on the Commission’s 2007 Green Paper on Financial Services, for example,
note a common view that confidence and trust are key for competitive and efficient retail
markets: ESC, Minutes, 11 October 2007.
The Commission has highlighted that consumers must be properly protected where appropriate and that providers must be financially sound and trustworthy, in addition to consumer empowerment: European Commission, Green Paper on Retail Financial Services,
pp. 2–3.
90
designing a retail investor protection regime
caveat emptor approach to the retail markets.343 Choice, the poster-child
of the empowerment model and closely linked to integration, appears
to be on the wane.344 Trust also has particular resonances in the EC
retail market given the heavy reliance on intermediation, whether through
advisers or sales channels (chapter 4) or in the form of the pan-EC preference for investment products rather than direct investments (chapter 3).
Given that trust appears to account for different participation levels across
countries345 and appears to vary across the Member States,346 measures
which support trust may also encourage investors to embrace the crossborder market and thereby achieve more effective diversification and protection against market risk.
It is not only the EC’s law-making and policy institutions which must
carefully balance empowered and trusting investor models. So too must
the European Court of Justice, particularly when interpreting the harmonized regime. The scale of the post-FSAP regulatory regime and the
increasing proliferation of CESR guidance and other soft law suggests
the Court will be called on to adjudicate on the new regime. The question therefore arises as to how the Court might characterize the EC retail
investor.
There is little evidence, thus far, of the Court’s approach to retail investor
protection. It has only rarely considered the interpretation of harmonized
rules in the financial markets sphere and this case law sheds little light on
the Court’s approach to investor protection, being largely concerned with
technical, scope-related matters. But some indications can be drawn from
the limited, pre-FSAP case law which addresses the extent to which Member States can impose national rules in the financial services and markets
343
344
345
346
Financial Services Consumer Group, Minutes, 3 July 2007, p. 4.
The European Parliament recently warned that ‘more is involved in the creation of an integrated European financial market than just providing consumers with more choice’ (European Parliament, Resolution on Financial Services Policy (2005–2010) (P6 TA(2007)0338,
2007) (‘Van den Burg II Resolution’), para. 36), while the Commission has accepted that
‘consumers often express the concern that a too wide choice of products may distract or
confuse them, complicating their selection of the product best suited to their needs’: Green
Paper on Retail Financial Services, p. 9.
E.g. R. La Porta, F. Lopez de Silanes, A. Shleifer and R. Vishny, ‘Trust in Large Organisations’
(1997) 87 American Economic Review 333 (finding cross-country variations, related to trust
levels, in, inter alia, government efficiency and economic performance).
A Eurobarometer study, for example, pointed to only 17 per cent of consumers of financial
services trusting advice from financial institutions in Greece, while 75 per cent and 71 per
cent of consumers trusted advice in Finland and Belgium: European Commission, Special
Eurobarometer No. 230, Public Opinion in Europe on Financial Services (2005), p. 21.
why intervene in the retail markets?
91
sphere which are restrictive of the Treaty freedoms in order to protect consumers of financial services.347 In the German Insurance case, the Court
examined the extent to which local consumer protection objectives could
justify restrictions on the provision of insurance by cross-border providers
in Germany in the form of, inter alia, establishment and authorization
requirements.348 The Court accepted that there was a public interest in
protecting the consumer given that insurance was a ‘mass phenomenon’,
the difficulties faced by consumers in assessing whether payments would
be made and the ‘precarious position’ in which consumers would be
placed were there a failure to pay.349 Although the Court did not accept
that all the German restrictions were valid, considerable sensitivity to the
risks faced by the consumer of complex financial products is clear. In
the investment context, in Alpine Investments,350 the Court accepted that
the Netherlands could impose a prohibition on cold-calling with respect
to off-market commodity futures (following a series of scandals) although
this restricted the ability of Netherlands-regulated firms to engage in cold
calls cross-border. Although investor protection was not directly at issue in
the case (the Netherlands’ public interest argument was based on the need
to protect the reputation of the Netherlands’ financial market), the Court
was again sensitive to the risks posed to retail investors by complex investments and, in particular, argued that investors were particularly reliant on
the competence and trustworthiness of financial intermediaries.351 The
Parodi ruling352 addressed banking and the restriction represented by a
French authorization requirement imposed before a Netherlands bank
could grant a Deutschmark mortgage to a French client. Although the ruling was concerned with the extent to which limited prior harmonization
in the banking field prevented France from imposing its authorization
requirements, the Court accepted that the banking sector was ‘particularly
sensitive’ from a consumer protection perspective, given the need to protect consumers from institutions which did not meet appropriate solvency
criteria or whose management did not possess the necessary integrity or
347
348
349
350
351
352
Reflecting the ‘general good’ jurisprudence which accommodates the interests of Member
States in imposing non-discriminatory but restrictive regulation, which furthers legitimate
social and public interests, with the Treaty freedoms.
Commission v. Germany [1986] ECR 3755 (Case 205/84).
Ruling of the Court, paras. 30–2.
Alpine Investments v. Minister van Financi¨en [1995] ECR I-1141 (Case C-384/93).
Ruling of the Court, paras. 42 and 46.
Soci´et´e Civile Immobili`ere Parodi v. Banque H. Albert de Bary et Cie [1997] ECR I-3899
(Case C-222/95).
92
designing a retail investor protection regime
professional qualifications. This case law suggests that the Court may be
somewhat reluctant to adopt an empowered approach to the investor,
although it has already accepted an empowerment-based model in the
consumer protection sphere.353
Ultimately, the lesson seems to be the obvious one. A careful blend of
both supply- and demand-side measures, and of trust- and empowermentbased strategies,354 is required in designing a retail market regime which
seeks to promote market engagement but responds to investor vulnerabilities and poor decision-making.355 The trusting investor may, over
time, and with empowerment-driven disclosure and education strategies, become more independent. Independent, competent and empowered investors, benefiting from a secure and well-designed foundation
of supply-side protections, can use disclosure and education strategies to navigate the financial markets more confidently. But, even if it
carefully blends the needs of vulnerable trusting investors and competent empowered investors, retail market intervention carries considerable risks. These risks, and the strategies which can be used
in mitigation, are considered in the remaining two sections of this
chapter.
II. The risks of retail market intervention
1. Regulatory and retail market agenda risks
The development of ‘good’ rules, or at least rules which do not have
malign effects, is difficult. The FSA’s move to outcomes-based and
353
354
355
The Court has generally supported consumer choice and the primacy of free trade over
protective national rules, and, in particular, favoured disclosure requirements over marketing restrictions, adopting a robust model of an informed, ‘reasonably circumspect’
and rational consumer (e.g. Mars [1995] ECR I-1923 (Case C-470/93); Gut Springenheide
GmbH [1998] ECR I-4657 (Case C-210/96); and Est´ee Lauder [2000] ECR I-117 (Case
C-220/98)). For an extensive discussion of the jurisprudence and of how the Court developed a model of a ‘rather robust self-reliant consumer’, see Weatherill, EU Consumer Law,
pp. 34–59. In particular, ‘the presence of a large block of prudent consumers who will not
be duped by a particular practice undermines the legitimacy of national measures designed
to suppress that practice, even where some gullible consumers would be prejudiced’: ibid.,
p. 57.
As appears to be acknowledged by Commissioner McCreevy: ‘if you look at the range of our
financial services policies, consumer protection, consumer empowerment, and consumer
choice is at the very core’: Commissioner McCreevy, Speech on ‘Increasing Financial
Capability’, 28 March 2007, available via http://europa.eu/rapid/searchAction.do.
La Blanc and Rachlinski, for example, argue for a multi-layered response, including firmfacing rules and investor education: In Praise, p. 22.
the risks of retail market intervention
93
more-principles-based regulation, for example, reflects its recognition
that earlier detailed retail market regulation, often in response to particular mis-selling crises, has not been successful in preventing investor
detriment.356
Regulators are vulnerable to monopoly risk and behavioural
weaknesses357 and operate in conditions of very considerable opacity
with respect to investor behaviour and the impact of law (as discussed in
section II.2 below); but the choices they must make are complex. The
mechanisms for delivering retail market outcomes are many, extending from regulation to include a multiplicity of institutions and market
actors.358 Rules which appear reasonable in isolation can have prejudicial effects; regulatory arbitrage risk in the retail markets is now considerable as investors are faced with a range of competing investment
products which can have investment, deposit and insurance components
and the risks from which are often not wholly captured by traditional
segmented regulation.359 Incentive risks, which are entrenched in the
retail markets, can be exacerbated by poor regulatory design; capital rules
can skew product design and distribution incentives.360 Badly designed
and costly regulation, notionally in support of the retail markets, can
damage innovation,361 generate incentives for firms to disengage from
the retail markets and limit retail investor returns; internationally, the
SEC has faced the criticism that its concern to promote fairness and
equal access by retail investors to issuer disclosure, which led to Regulation Fair Disclosure, risked damage to market efficiency by ‘chilling’
the supply of information.362 The retail market agenda has certainly
driven poor regulatory design in the EC. The controversial prohibition
on price improvement for retail investors under MiFID’s equity market
356
357
358
359
361
362
FSA, Reforming Conduct of Business Regulation (Consultation Paper No. 06/19, 2006),
p. 13. FSA Chief Executive Tiner noted that prescriptive rules had ‘not produced the
vibrant, customer-oriented market needed’: Keynote Speech to FSA More PrinciplesBased Regulation Conference, 23 April 2007, available via www.fsa.gov.uk/Pages/Library/
Communications/Speeches/index.shtml.
Choi and Pritchard, ‘Behavioral Economics’.
J. Black, ‘Mapping the Contours of Contemporary Financial Services Regulation’ (2002)
2 Journal of Corporate Law Studies 253.
See further ch. 4. 360 See further ch. 4.
E.g. L. Zingales, The Costs and Benefits of Financial Market Regulation (2004), ssrn
abstractid=536682.
E.g. Z. Goshen and K. Parchomosky, ‘On Insider Trading, Markets and Negative Property
Rights in Information’ (2001) 87 Virginia Law Review 1229 and S. Choi, ‘Selective Disclosure in the Public Capital Markets’ (2002) 35 University of California (Davis) Law Review
533.
94
designing a retail investor protection regime
transparency regime,363 for example, has been associated with an illconsidered investor protection justification.364
The risks and complexities are compounded by the rapid pace of innovation and the repeated failure of regulation to capture evolving retail market
risks. In the UK, this was earlier made clear by the mis-selling of splitcapital investment trusts (chapter 3). The 2008 Lehman collapse has since
led the FSA to focus not only on the marketing of those structured products
which were backed by a failed Lehman guarantee but on the retail structured products industry more generally;365 the FSA was, however, initially
somewhat sanguine, despite its 2004 Financial Risk Outlook earlier pointing to the risks to investors from guaranteed structured products.366 And
it is not complex product regulation which appears to have failed in these
cases, but core disciplines concerning marketing and the quality of advice.
The risks of political over-reaction are also considerable.367 The personal
finance agenda is now of some political importance and regulation may
come under pressure to deliver unrealistic outcomes.368 Although the
retail markets have not featured prominently in the financial crisis reform
agenda, wider public engagement with the markets has led to the financial
crisis being examined as exposing the ‘too many to fail’ problem.369
The pressure on regulation is further increased by an unhelpful retail
cohort with only limited ability to monitor firms, decode disclosures and
mitigate the risks of poor regulatory design.
An investor protection/retail market mandate might focus regulator
attention on retail market interests, drive better regulation and create a
public perception of a regulator not captured by industry interests;370 this
might also support stronger market engagement. But there are risks to
the retail market agenda. Investor confidence, which is closely associated
with retail market intervention, is a challenge to capture in cost/benefit
analysis and, as a regulatory objective, risks passing excessive powers to the
363
364
365
366
367
368
369
370
Art. 27(3).
As was suggested by a London Stock Exchange Chairman: D. Cruikshank, Speech on
‘The Impact of the EU Financial Services Action Plan on the Regulation of EU Securities
Markets’, 6 March 2003, available via www.londonstockexchange.com.
J. Hughes, ‘Products Backed by Lehman Spark FSA Probe’, Financial Times, 8 May 2009,
p. 3.
FSA, Financial Risk Outlook 2004, p. 64.
E.g. R. Romano, ‘The Sarbanes–Oxley Act and the Making of Quack Corporate Governance’ (2005) 114 Yale Law Journal 1521.
J. Gray, ‘Personal Finance and Corporate Governance: The Missing Link: Product Regulation and Policy Conflict’ (2004) 4 Journal of Corporate Law Studies 187, 190.
Zingales, Future of Securities Regulation, pp. 9 and 18.
Hamilton and Gray, Implementing Financial Regulation, p. 193.
the risks of retail market intervention
95
regulator.371 Productive competition between regulators may be dulled by
retail market mandates.372 A retail market mandate may also lead to an
undue and potentially risky ‘consumerization’ of financial market regulation. Wholesale market regulation may as a result be inadequate and consequent failures in the wholesale markets may ultimately prejudice retail
investors.373 Weaknesses in the SEC’s treatment of speculative trading by
institutional investors over the dotcom period, for example, have been
related to the SEC’s being ‘stuck in a paradigm of investor protection’.374
In its response to the financial crisis, the FSA has suggested that its balancing of conduct-of-business regulation (strongly associated with the retail
markets) and prudential regulation may have been wrong, with insufficient attention paid to prudential regulation.375 On the other hand, it is
doubtful whether the attractions of the retail agenda can be blamed for
the international failure to focus sufficiently closely on the wholesale markets; it is much more likely that the long-standing assumption as to the
resilience of market discipline in certain segments has been more influential and that the danger that the retail interest is insufficiently considered
in the reform process is real.376 But it is also clear that failures to address
the wholesale markets can have catastrophic effects for retail investors.
2. Regulation and the retail markets: ‘laws on the books’
and ‘laws in action’
The extent to which regulatory strategies can deliver retail market
objectives is also unclear. The relationship between law and financial
371
372
373
374
375
376
Although efforts have been made to quantify investor confidence (e.g. J. Hochberg,
P. Sapienza and A. Vissing-Jørgensen, ‘A Lobbying Approach to Evaluating the Sarbanes–
Oxley Act of 2002’ (2009) 47 Journal of Accounting Research 519), it is a nebulous objective
and can mask regulatory aggrandizement.
CSES Report, suggesting that regulators, such as the AMF, with an express mandate to
protect individual investors’ savings, are less inclined to compete with respect to issuer
prospectus matters than other regulators: p. 20.
Garten, ‘Consumerization’, 304–7.
R. Karmel, ‘Mutual Funds, Pension Funds and Stock Market Volatility – What Regulation
by the Securities and Exchange Commission Is Appropriate?’ (2004–5) 80 Notre Dame
Law Review 909, 912.
Turner Review, p. 87.
The FSCP took issue with the Turner Review’s suggestion as to over-reliance on conductof-business regulation, suggesting that repeated failures in the banking industry show that
the ‘FSA cannot be allowed to think that it has the regulation of the consumer facing
side of financial services under control’: FSCP, Press Release, 18 March 2009. The FSA has
now established a Conduct Risk Division to ensure sufficient attention to conduct matters
while prudential matters dominate.
96
designing a retail investor protection regime
market development has become the subject of an innovative and vibrant
scholarship over the last decade or so. Significantly for the transformative
ambitions of retail market policy, it asks whether ‘law matters’ to financial
market development.377 It models the relationship between capital market
rules (particularly on informational and agency problems in the public
securities markets) and indicators of economic development and financial sector growth (such as the value of stock markets, numbers of listed
firms and levels of dividend payouts).378 The initial research focused on
‘laws on the books’379 and suggested that strong securities markets and
lower costs of capital are related to strong investor protection laws. But,
even if a correlation could be drawn between this research and the impact
of law on retail market behaviour, the causal relationship between law
and strong markets is fiercely contested.380 Recent scholarship suggests,
however, that enforcement (and so ‘law in action’) is a driver of strong
markets.381 This line of scholarship, perhaps, holds the most important
lesson for retail market regulation.382 The strenuous efforts expended in
shaping the disclosure provided to retail investors and its limited effects
(chapter 5), and the difficulties regulation faces in dealing with entrenched
377
378
379
380
381
382
It is spearheaded by the work of financial economists La Porta, Lopez de Silanes, Shleifer
and Vishny (e.g. R. La Porta, F. Lopez de Silanes, A. Shleifer and R. Vishny, ‘Law and
Finance’ (1998) 106 Journal of Political Economy 1113), reviewed in S. Choi, ‘Law, Finance,
and Path Dependence: Developing Strong Securities Markets’ (2002) 80 Texas Law Review
1657; and J. Coffee, ‘Law and the Market: The Impact of Enforcement’ (2007), ssrn
abstractid=967482.
E.g. R. La Porta, F. Lopez de Silanes, A. Shleifer and R. Vishny, ‘Legal Determinants of
External Finance’ (1997) 52 Journal of Finance 1131.
Although the research has now turned to address enforcement, for example R. La Porta,
F. Lopez de Silanes, A. Shleifer and R. Vishny, ‘What Works in Securities Laws’ (2006) 61
Journal of Finance 1.
E.g. L. Guiso, P. Sapienza and L. Zingales, ‘Does Culture Affect Economic Outcomes?’
(2006) 20 Journal of Economic Perspectives 23; R. Rajan and L. Zingales, ‘The Great Reversals: The Politics of Financial Development in the Twentieth Century’ (2003) 69 Journal
of Financial Economics 5; J. Coffee, ‘The Rise of Dispersed Ownership: The Roles of Law
and the State in the Separation of Ownership and Control’ (2001) 111 Yale Law Journal
1; and B. Cheffins, ‘Does Law Matter?: The Separation of Ownership and Control in the
United Kingdom’ (2001) 30 Journal of Legal Studies 459.
E.g. E. Ferran and K. Cearns, ‘Non-Enforcement-Led Public Oversight of Financial and
Corporate Governance Disclosure and of Auditors’ (2008) 8 Journal of Corporate Law
Studies 191; H. Jackson and M. Roe, Public and Private Enforcement of Securities Laws:
Resource-Based Evidence (2008), ssrn abstractid=1000086; Coffee, Law and the Market;
and H. Jackson, ‘Variations in the Intensity of Financial Regulation: Preliminary Evidence
and Potential Implications’ (2007) 24 Yale Journal on Regulation 253.
‘[S]imply because something is enacted into law, clearly or not, does not tell us much about
how strongly it will influence economic behaviour’: D. Langevoort, The Social Construction
of Sarbanes–Oxley (2006), ssrn abstractid=930642, p. 2.
the risks of retail market intervention
97
commission-based conflict-of-interest risks (chapter 4), certainly caution
against expecting too much of regulation ‘on the books’.
The FSA provides an instructive example of the distinction between
‘laws on the books’ and ‘laws in action’. Its retail market activities currently
include the supply-side, non-regulatory TCF initiative and the RDR.383 As
discussed in chapter 4, the TCF strategy is designed to translate regulatory fairness requirements into operational outcomes ‘in action’. While
the RDR is concerned with regulatory reform, as discussed in chapter
4 it extends far beyond the traditional process-based concerns of advice
regulation; regulation is used to re-engineer the structure of the advice
and sales market and to simplify the advice environment. This ‘in action’
model is rooted in the UK market and reflects the dynamics of FSA culture
and decision-making.384 But it is not unreasonable to suggest that regulation ‘on the books’ alone is unlikely to deliver retail market objectives.
The EC’s regulatory retail market efforts therefore represent only a partial
strategy and its success is likely to depend heavily on the effectiveness of
local ancillary strategies ‘in action’.
3. Responding to the drivers of retail market engagement
Much remains to be done before regulators will have a deep understanding
of retail investor behaviour; until knowledge improves, regulation remains
risk-laden. Much also remains to be done with respect to understanding of
the drivers of retail market engagement. Trust-based and empowermentbased retail market strategies are both concerned with investor engagement
with the markets. But the drivers of investor behaviour and of household market engagement are not well understood.385 Why investors invest
is straightforward – to make money;386 investments might similarly be
characterized in terms of their ability to increase the investor’s financial
resources.387 But this masks the range of factors (including trust in the
383
384
385
386
387
FSA, Major Retail Thematic Work Plan for 2007–2008, p. 1; and FSA, Business Plan 2008–
2009, p. 23. The retail market strategy also includes demand-side, non-regulatory financial
capability initiatives.
The TCF initiative is related to the FSA’s identification of the retail market as of ‘greatest structural concern’: Speech by FSA Chief Executive Sants on ‘Judgments on Judgments – Retail Firms and Principles-Based Regulation’, 27 February 2008, available via
www.fsa.gov.uk/Pages/Library/index.shtml.
Relatively little is known about individual investors’ money management and there is a
shortage of high-quality data: Ivkovich and Weisbenner, ‘Local Does as Local Is’.
Stout, ‘Investor Confidence Game’, although this covers a range of other motivations given
the different drivers for seeking personal wealth: Langevoort, ‘Selling Hope’.
Oxera, Towards Evaluating Consumer Outcomes in the Retail Investment Products Markets:
A Methodology: Prepared for the Financial Services Authority (2008), p. 1.
98
designing a retail investor protection regime
markets and in regulation) which drive investment.388 If non-participation
is a function of factors which are amenable to regulation (as trust appears
to be) then law may be able to support engagement.389 In practice, however, not all the factors which appear to drive participation390 are easily
susceptible to intervention.
They range from the tendency of households to follow other households391 and the influence of neighbours, peers392 and family,393 to tax
incentives,394 behavioural factors,395 age396 and cultural factors.397 Participation is also related to household wealth398 and education,399 different
savings motivations,400 financial literacy401 and the costs of investing.402
It is influenced by house price volatility and pressure to become a homeowner,403 the impact of privatization programmes404 and the availability
of pension provision.405 Economic stability, as the financial crisis has made
graphically clear, is also strongly associated with retail investor engagement
with the markets.406
388
389
390
391
393
395
396
397
398
399
401
402
403
404
405
406
Investment has been described as displaying utilitarian (low risk and high returns) and
expressive (status, patriotism and social responsibility) benefits: M. Statman, ‘What Do
Investors Want?’ (2004) Journal of Portfolio Management 153.
H. Hong, J. Kubik and J. Stein, ‘Social Interaction and Stock-Market Participation’ (2004)
59 Journal of Finance 137.
For a review of the evidence, see V. Corragio and A. Franzosi, Household Portfolio and
Demand for Equity: An International Comparison (Blt Notes No. 19, Borsa Italiana, 2008),
pp. 5–6. The range of influences on limited French household participation, for example, have been identified as including loss aversion, tax disincentives, high participation
(including information) costs and transaction costs: French Savers, p. 1.
Campbell, ‘Household Finance’, 1569. 392 Hong et al., ‘Social Interaction’.
French Savers, p. 15. 394 Campbell, ‘Household Finance’, 1569.
Including loss aversion, optimism and subjective expectations as to stock market performance: Guiso and Zingales, Trusting the Stock Market, p. 3.
Shum and Faig, ‘What Explains’.
W. de Bondt, ‘The Values and Beliefs of European Investors’ in Cetina and Preda, Sociology
of Financial Markets, p. 163.
AMF, L’´education financi`ere des Franc¸ais (2004).
E.g. Guiso et al., Household Stockholding, pp. 11–13. 400 Shum and Faig, ‘What Explains’.
E.g. Guiso and Japelli, ‘Awareness’; and Haliassos and Bertaut. ‘Why Do So Few Hold
Stocks?’
Shum and Faig, ‘What Explains’; and Guiso et al., Household Stockholding.
J. Banks, R. Blundell and J. Smith, ‘Understanding Differences in Household Financial
Wealth Between the US and Great Britain’ (2003) 38 Journal of Human Resources 241.
Guiso et al., Household Stockholding. Repeated French privatizations, for example, have
led to significant small household equity portfolios: French Savers, pp. 12–13.
Guiso et al., Household Stockholding, p. 16.
As EFAMA noted in its analysis of the massive outflows from the UCITS industry in the
final quarter of 2008: EFAMA, Quarterly Statistical Release No. 36 (2008), p. 2.
the risks of retail market intervention
99
Policy attention is increasingly turning to understanding why households do not engage with the markets. The Deaves review of investor
behaviour for Canada’s securities regulation reform, for example, highlighted the deterrent effect of transaction costs.407 The 2008 Rand Report,
commissioned by the SEC, highlighted limited resources, the fear of losing
money, lack of knowledge, a perception that large amounts of disposable
income are required for investment activity and the complexity of the
financial service industry as deterrents to investment.408 FSA research, as
part of the RDR, has identified a range of factors which may deter low
to middle incomes from market savings,409 while other FSA research has
identified the range of environmental factors which may influence consumer behaviour with respect to financial services, including investment
services.410 The AMF has also examined the drivers of investment.411
These findings are echoed in the 2007 BME Report. It reported a strong
relationship between GDP per capita and the aggregate volume of household financial assets.412 It linked the initial 1980s move towards equity
investment to (then) high stock returns, privatizations413 and the growth
of CISs.414 It also related investment patterns to taxation,415 cultural factors and market structure factors (such as the importance of listed investment trusts (or companies) in the UK market).416 It highlighted occupational pension provision as a significant local driver of investment,417
contrasting the comparatively low levels of direct CIS investment in the
UK and the Netherlands with very high levels of investment in those
407
409
410
411
412
413
414
415
416
417
Deaves Report, pp. 264–5 and 281. 408 Rand Report.
Including age, employment status, education, housing, ability to save and pension provision: Volterra Consulting, The Market for Basic Advice: A Report for the FSA (2008).
FSA, Consumer Research No. 35, pp. 13–27. More recently, FSA research has linked the
likelihood of households holding investment products to higher income and education
levels, home ownership and higher overall wealth: FSA, Asset Ownership, Portfolios and
Retirement Saving Arrangements: Past Trends and Prospects for the Future (Consumer
Research No. 74, 2008), p. 3.
Highlighting insufficient resources (65 per cent of respondents) and being overwhelmed
and poorly informed (21 per cent): AMF, L’´education financi`ere des Franc¸ais.
BME Report, p. 21.
Ibid., pp. 167–8. Successive privatization rounds in France, for example, created a large
number of small household equity portfolios (French Savers), as they did in the UK.
Also, Guiso et al., Household Stockholdings, p. 2.
Also, FSA, Response to the European Commission’s Call for Evidence on the Need for a
Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’
Retail Products (2008) (‘FSA Structured Products Response’), p. 9 (although tax incentives
appear to have only limited impact in practice: BME Report, p. 155).
And the availability of ‘with profits’ insurance products: ibid., p. 9.
BME Report, pp. 151–4 and 163–5.
100
designing a retail investor protection regime
countries in pension funds and life insurance products; but countries
which have not moved significantly from the ‘pay as you go’ pension
model had higher levels of CIS investment.418 Local home ownership
patterns have also been identified as relevant; high levels of home ownership in the UK and the related concern to repay mortgages have been
associated with high levels of UK investment in packaged products.419
Economy-specific effects have also been highlighted; the Italian experience
with inflation has been associated with a retail investor concern for high
returns.420
Crafting retail market regulation is accordingly a challenge. Retail market intervention carries risks, the impact of regulation remains unclear
and, when it comes to engaging investors, many of the relevant factors are
not susceptible to regulation. The difficulties are all the greater in the EC
context.
4. Centralization risks
An even cursory review of retail market policy in different markets internationally leads to the intuitive conclusion that it is deeply rooted in
the risks posed by, and reflects long-standing investment cultures within,
local markets. Internationally, Australian regulatory priorities, for example, reflect the innovative Australian compulsory superannuation regime
which requires employees to save for retirement through superannuation
funds and which allows employees to choose the fund in which employer
pension contributions are invested;421 retail market policy is accordingly closely concerned with the quality of investment advice on fund
choice, product disclosure and financial literacy.422 In Europe, debt market risks to retail investors are of particular concern to the Italian regulator,
418
419
420
421
422
Ibid., p. 90.
HM Treasury, Notification and Justification for Retention of the FSA’s Requirements on the
Use of Dealing Commissions under Article 4 of Directive 2006/73/EC Implementing Directive
2004/39/EC and Notification and Justification for Retention of Certain Requirements Relating
to the Market for Packaged Products under Article 4 of Directive 2006/73/EC Implementing
Directive 2004/39/EC (2007) (‘UK Article 4 Application’).
Response to Commission’s Call for Evidence on Debt Market Transparency by a group of
thirteen leading trade associations, September 2006, p. 13.
It has prompted very high levels of pension contributions: J. Shingleton, ‘Australia Acts to
Reassure Pensioners’, Financial Times, Fund Management Supplement, 1 December 2008,
p. 11.
E.g. Speech by ASIC Chairman Lucy on ‘ASIC’s Super Strategies 2006–2007’, 6 September
2007, available via www.asic.gov.au.
the risks of retail market intervention
101
CONSOB.423 The Dutch financial regulator has recently focused on structured product risks, reflecting their popularity in the Dutch market.424
The UK FSA, by contrast, was initially more sanguine given their more
limited penetration in the UK market.425 Conversely, the FSA is focusing
closely on the design of the distribution and advice industry, reflecting the
importance of commission-based advisers in the UK market.426 In principle, therefore, extensive harmonization of retail market rules, and the
apparently inexorable movement of the Community into the management
of emerging retail market risks, gives some pause for thought.
As discussed in chapter 1, the scope of the post-FSAP investor protection
regime and its increasing degree of prescription suggest that the EC is fast
becoming the monopoly supplier of retail market regulation. A range
of risks accordingly arise, related to the wider debate on the merits of
regulatory competition and harmonization.427 Specific retail market risks
include industry interest-group pressures given poor retail governance
(chapter 7). The EC’s response to retail market risk may also become
less informed by local rules and innovations. Systemic regulatory risks
may be increased as EC regulatory decisions are injected into all local
markets. Greater centralization also jars with wide variations in investment
patterns428 and in investor competence, different distribution structures429
and varying attitudes towards financial services,430 all of which suggest that
a flexible regulatory approach is required.431
423
425
426
427
428
430
431
Sect. III.6 below. 424 E.g. AFM, Exploratory Analysis of Structured Products (2007).
FSA Structured Products Response. It has since opened a review into the retail structured
products market: Hughes, ‘Products’.
See further ch. 4.
E.g. L. Enriques and M. Gatti, ‘The Uneasy Case for Top-Down Corporate Law Harmonization in the European Union’ (2006) 27 University of Pennsylvania Journal of International
Economic Law 939.
See further ch. 1. 429 Ch. 4 sect. X.
The Eurobarometer has reported significant differences in the extent to which consumers
of financial services regard consumer rights to be adequately protected, ranging from
significant agreement with the statement that consumer rights are adequately protected
by Finnish (60 per cent), Luxembourg (58 per cent), Belgian (44 per cent) and Danish
(43 per cent) respondents, to disagreement by Greek (56 per cent), Swedish (53 per cent),
Italian (50 per cent) and French (49 per cent) respondents: European Commission, Special
Eurobarometer No. 202, Public Opinion in Europe: Financial Services, and Eurobarometer
Highlights (2004), p. 12.
FIN-USE, the Commission’s retail market forum, has repeatedly cautioned against the
removal of local consumer protection rules: for example, FIN-USE, Financial Services,
Consumers and Small Businesses: A User Perspective on the Reports on Banking, Asset
Management, Securities and Insurance of the Post FSAP Stock Taking Groups (2004), p. 5.
102
designing a retail investor protection regime
Local innovations may also be obstructed by EC requirements. In the
UK, the FSA sought and received confirmation from the Commission
that the Child Trust Fund (CTF), a tax wrapper which holds savings and
investments and into which the government makes a contribution per
child, and which has distinct product features, does not come within
MiFID’s scope.432 This exclusion has allowed the FSA to retain a tailored
disclosure regime for CTFs.433 The ‘stakeholder’ products regime also
operates outside MiFID as does, for the most part, the personal investment
firm regime. But national initiatives and harmonized rules do not always
fit easily together. As discussed in chapter 4, MiFID may pose an obstacle
to the development of more limited advice regimes designed to promote
wider access to advice. The constraints posed by the UCITS summary
prospectus have also been associated with obstructing Member States in
adopting more innovative prospectus formats for fund disclosure.434
There are countervailing factors. The EC regime is not monolithic
(chapter 1); local variation is possible with respect to rules on the books
and supervisory techniques ‘in action’. MiFID’s principles-based model
(chapters 4 and 5) also allows supervisors considerable freedom should
they choose to proceed by way of guidance and supervisory practices.
Evidenced-based policy formation and rule-making is on the increase
(section III below), and CESR provides a forum through which national
expertise can inform policy-making (chapter 7). Safety valves are also built
into the regime. Member States can notify the Commission of additional
local rules under the MiFID Article 4 ‘goldplating’ regime, for example,
while the Prospectus Directive leaves significant room to Member States
to impose advertising requirements on the public offer of securities.
III. How to intervene on the retail markets?
1. The regulatory toolbox and self-regulation
The challenge for retail design is therefore considerable. Regulation must
blend trust-based and empowerment-based strategies, effectively support
432
433
434
FSA, Child Trust Funds and MiFID (2005).
Firms selling CTFs are subject to a ‘balanced comparison’ rule which requires them to
disclose which of the three types of CTF are being sold and which is designed to ‘reflect
the unique nature of this product (which is uniquely marketed to many who will not have
previously engaged in financial services)’: FSA, Consultation Paper No. 06/19, p. 122.
See further ch. 5.
how to intervene on the retail markets?
103
stronger engagement and contain the risks of regulatory design. Sophisticated regulatory technology is called for.
The main retail market regulatory mechanisms can be placed on a
spectrum which extends from interventionist supply-side product design
and advice/distribution rules, to techniques which support private ordering (typically disclosure-based), to non-regulatory techniques, typically
investor education strategies.435 This spectrum is reflected in the EC
investor protection regime. In addition to disclosure (chapter 5) and
investor education (chapter 7), it relies on product regulation (primarily through the UCITS regime (chapter 3)) and on horizontal distribution/advice measures (primarily through MiFID (chapter 4)), as well as
on specific rules for order execution (chapter 6) and education strategies
(chapter 7).
All of these levers must be manipulated simultaneously. But they
are of varying utility. Disclosure is receding in significance but, reflecting empowerment priorities, remains a prominent mechanism in the
retail markets; ‘processability’ reforms account for significant regulatory
resources. It has long-term potential as an investor education tool. But
investor difficulties with disclosure are of such a scale that it is poorly
suited to addressing immediate risks. Investor education is similarly limited. Product regulation can mitigate understanding and disclosure risks
as well as the conflict-of-interest risks associated with advice. But it is a
particularly interventionist form of regulation and carries considerable
risks.
Since MiFID’s adoption, the horizontal advice and product distribution
process,436 and the management of quality of advice risks, has moved to
the centre of retail market policy, as discussed in chapter 4. Reliance on the
distribution lever is efficient. Heavy reliance on advisers recurs across the
Member States.437 The 2008 Optem Report438 found that those investors
who can be characterized as consumers of investment products and prudent ‘savers’,439 and who dominate in the EC market, tend to rely heavily
435
436
437
438
439
S. Choi, ‘A Framework for the Regulation of Securities Market Intermediaries’ (2004) 1
Berkeley Business Law Journal 45.
The FSA regime, which, post-MiFID, is now closely based on EC requirements, has long
been associated with a focus on advice rather than on products: Black, Rules and Regulators,
pp. 139–40.
Intermediaries are the main information source for investors in Spain, Italy and France:
BME Report, p. 175.
Optem Report, pp. 88 and 93–4.
As compared with more experienced direct and more risk-tolerant investors (or
‘gamblers’).
104
designing a retail investor protection regime
and passively on advice.440 This reflects national studies which suggest
retail investor reluctance to engage with disclosure and to exercise independent choice.441 It also reflects wider evidence on investor behaviour442
and on investor trust in intermediaries. As outlined in chapter 4, the
horizontal advice lever can also carry heavier loads than the design and
disclosure levers. Nonetheless, the distribution lever is awkward. The management of commission risk has proved elusive, while the translation of
suitability rules ‘on the books’ to high-quality advice ‘in action’ can be
very difficult to achieve.
Market solutions can also be called on. The post-FSAP retail market
regulatory regime is strongly characterized by traditional ‘command and
control’ regulation.443 But EC financial market regulation more generally
was showing some signs of a more decentred approach and beginning to
involve market actors in disciplining markets.444 Self-regulation appears,
however, to be on the wane in the wake of the financial crisis.445 Selfregulation in the retail markets is, in principle, problematic. Investors
are poorly equipped to monitor market actors and to price protections.
440
441
442
443
444
445
As do inexperienced consumers.
The TNS-Sofres Report found that French CIS investors relied heavily on banks or financial
advisers: pp. 7 and 10. The FSA has frequently highlighted the failure of investors to read
disclosures and their preference for advisers (64 per cent of all reported retail investment
products were sold on an advised basis in 2007/8 (68 per cent in 2006/7): FSA, Retail
Investments Product Sales Data Trends Report September 2008 (2008), p. 2): for example,
Consumer Research No. 76, p. 12 and Consumer Research No. 41, p. 8. It has identified
advisers as a ‘key interface between the financial services industry and its consumers’:
Financial Risk Outlook 2005, p. 88. FSA research into the simplified Basic Advice regime,
for example, found that transactions were adviser-driven and that there was little evidence
of active decision-making: Consumer Perceptions of Basic Advice (Consumer Research No.
70, 2008), p. 6.
Deaves Report, pp. 247 and 262; and Investment Company Institute, Understanding Investor
Preferences for Mutual Fund Disclosure (2006), p. 6.
By contrast, soft law techniques are increasingly being employed in the consumer sector more generally: C. Poncibo, The Challenges of EC Consumer Law (2007), ssrn
abstractid=1028218.
N. Moloney, ‘Law-Making Risks in EC Financial Market Regulation after the Financial
Service Action Plan’ in S. Weatherill (ed.), Better Regulation (Oxford and Portland, OR,
Hart Publishing, 2007), p. 321.
Best exemplified by the Commission’s change of position on credit rating agencies and
its adoption of a regulatory model (COM (2008) 704; a Regulation was adopted in
April 2009) in preference to its previous reliance on the self-regulatory IOSCO Code of
Conduct (2004). The de Larosi`ere Report, however, was ‘mindful of the usefulness of selfregulation’ and suggested that ‘public and self-regulation should complement each other’
(p. 15).
how to intervene on the retail markets?
105
Retail stakeholders are often hostile.446 But self-regulation has flexibility,
speed and innovation benefits and some retail market potential – not least
because the wider the range of tools used, the more likely it is that an
effective response will emerge.
There is some evidence that the FSA is increasingly sceptical of selfregulation in the retail markets with its recent extension of conduct-ofbusiness regulation to the deposit-taking activities of banks.447 Nonetheless, it has engaged firms and market solutions in its retail market
activities,448 particularly through the TCF initiative and related industry actions;449 it has suggested that a combination of the TCF agenda and
industry initiatives should lead to fairer consumer outcomes.450 It has supported trade associations in developing best practice disclosure guides.451
The RDR, which is designed to achieve outcomes in partnership with the
industry,452 ‘challenged the industry’ to develop an enhanced framework
for professional standards453 and called for an enhanced role for professional bodies.454 In its extensive review of bundling and soft commissions
446
447
448
449
450
451
452
453
454
‘[I]t can easily come to mean nothing more than unconstrained action by suppliers’:
FIN-USE, User Perspective, p. 14.
It has proposed that the current self-regulatory regime, based on the voluntary Banking
Code and the Business Banking Code, which applies to the conduct of business in the retail
banking area and with respect to the sale of current and savings accounts, be replaced
by a regulatory approach and a new BCOBS sourcebook which will include the fair
treatment principle and disclosure requirements: Regulating Retail Banking Conduct of
Business (Consultation Paper No. 08/19, 2008). A new BCOBS will come into force at the
end of 2009.
It has identified the ‘different levels of market solution’ in the UK regulatory regime as
including FSA reliance on high-level principles, FSA endorsement of industry guidance
and the involvement of professional bodies in the delivery of high standards of adviser
competence and professionalism: FSA Substitute Products Response, p. 19.
The Association of British Insurers’ multi-faceted ‘Customer Impact Scheme’, which
reflects the TCF initiative and is designed to focus firms on consumer outcomes
(ABI, Customer Impact Scheme (2006)), was developed in consultation with the FSA
(Speech by A. Sykes, FSA KFD Seminar, 6 May 2008, available via www.fsa.gov.uk/
Pages/Library/index.shtml).
FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers
(Policy Statement No. 07/11, 2007), p. 15 (although the FSA also highlighted that industry
efforts alone would not bring the necessary changes to firms’ behaviour).
Consultation Paper No. 06/19, p. 124; and FSA, Good and Poor Practices in Key Features
Documents (2007).
The FSA’s preference was ‘for market- not regulatory-led ideas’ and to facilitate industry
ideas: 2007 RDR, pp. 12 and 15.
2008 Interim RDR, p. 2.
The FSA suggested that the industry should lead the way on professionalism and competence standards: 2007 RDR, pp. 38–40. The final 2008 Feedback Statement suggests that
the industry will be closely involved in the design of a new Professional Standards Board.
106
designing a retail investor protection regime
in the CIS industry, the FSA eschewed a regulatory response in favour
of allowing the industry to develop techniques which would show that
customers were being treated fairly with respect to soft commissions.455
Attempts to incorporate market solutions are not confined to the UK.
France’s Delmas Report, for example, called for industry initiatives on
investment adviser competence and for its recommended conduct-ofbusiness reforms to be implemented as trade association rules approved
by the regulator.456 Self-regulatory initiatives by trade associations have
been incorporated by the Dutch regulator in its response to the risks of
structured products.457
Although self-regulation strategies are not yet of notable importance in
the EC retail investor regime, elements of self-regulation do appear. The
empowerment model for retail market intervention suggests that the retail
investor is, to some degree, being engaged as a self-regulating, risk-aware
participant in the marketplace. Principles-based regulation is associated
with self-regulation and MiFID’s principles-based approach is likely to
see industry guidance become more prominent. A threat of intervention
dynamic is also injecting a hybrid form of self-regulation under which
industry responses are dictated by Commission priorities. Retail debt market transparency is based on industry compliance with a voluntary standard which was developed under the threat of Commission intervention
(section III.6 below). The structured products debate has seen a group of
leading trade associations develop a code of practice which may be, in part,
an attempt to forestall regulatory intervention.458 The Unfair Commercial Practices Directive, which expressly refers to the possibility of unfair
commercial practices being addressed by codes of conduct (Article 10),
provides a useful model for how self-regulation can be ‘hardened’ by linking failure to comply with a code of conduct to a determination that a
commercial practice is misleading (Article 6).
2. Achieving retail market outcomes
The risks of intervention, and better achievement of retail market
objectives, can be mitigated by a focus on the particular outcomes
455
456
457
FSA, Bundled Brokerage and Soft Commission Arrangements for Investment Funds (Policy
Statement No. 06/5, 2006). The FSA also relies on the industry standards adopted by
leading fund management trade associations in assessing whether firms’ soft commissions
disclosure is ‘adequate’, as required under the FSA’s COBS sourcebook.
Delmas Report, pp. 48–9.
It has also relied on the Financial Services Foundation (the StFD). 458 See further ch. 3.
how to intervene on the retail markets?
107
sought.459 Clear identification of outcomes is also essential to effective
principles-based regulation, as discussed below. The FSA’s retail market
activities are based on the achievement of the outcomes identified in its
annual Business Plan460 and in its Major Retail Thematic Work Plan.461
This approach cascades down to specific initiatives. The TCF initiative is
based on the achievement of specified outcomes which describe the characteristics of the retail market sought by the FSA.462 The RDR is designed to
support a market in which consumers are capable and confident, information is clear, simple and understandable, and firms are soundly managed
and treat customers fairly.463
The Commission supported an ‘impact-driven approach’ and ‘making
markets deliver more effectively’ in the 2007 Single Market Review,464 and
is to ‘shift the focus of regulation towards citizen-focused outcomes’ in
its consumer policy.465 It is also, slowly, turning to the outcomes of retail
market intervention in specific measures466 and more generally. The 2007
Green Paper on Retail Financial Services suggests that the Commission
seeks a market in which: properly regulated markets and strong competition deliver products that meet consumers’ needs; consumer confidence
is enhanced through protective measures; and consumers are empowered
459
460
461
462
463
464
465
466
The Sandler Report, for example, suggested that, in a well-functioning retail savings
market, there would be: reasonable understanding of retail savings products; a properly
functioning advice market; alignment of advisers and consumer incentives; simple and
straightforward products; downward pressure on price and upward pressure on quality;
clear price identification; and easy access to products and services, particularly for the
low-to-middle-income group: p. 22.
The 2008–2009 Business Plan focused in particular on the TCF initiative, the sound
resourcing and management of firms, the RDR, and financial capability: FSA, Business
Plan 2008–2009, p. 23. Similar outcomes were specified in the 2009–2010 Business Plan.
Areas of concern identified for thematic review are typically assessed through file reviews,
discussions with firms, consumer surveys and research, and mystery-shopping surveys:
FSA, Transparency as a Regulatory Tool (Discussion Paper No. 08/3, 2008), p. 41.
See further ch. 4.
2007 RDR, p. 3. The final 2008 report stated the outcomes as: an industry that engages
with consumers in a way that delivers more clarity; a market which allows consumers’
needs and wants to be addressed; standards of professionalism that inspire consumer
confidence and build trust; remuneration arrangements that allow competitive forces to
work for consumers; sufficient industry viability to deliver long-term commitments and
firms which treat customers fairly; and a supportive regulatory framework which does not
inhibit future innovation beneficial to consumers: 2008 RDR Feedback Statement, p. 5.
European Commission, A Single Market for 21st Century Europe (COM (2007) 724),
para. 1.
European Commission, Communication on EU Consumer Policy Strategy 2007–2013, p. 3.
The UCITS Key Investor Information (KII) reform, for example, recognizes the importance of clarifying outcomes (ch. 5).
108
designing a retail investor protection regime
to make the right decisions for their financial circumstances.467 The ability of the EC to articulate clear outcomes for retail market intervention,
particularly in the absence of an institutional statement on the objectives
of EC intervention in the financial markets,468 will become all the more
important as policy questions of central importance to the retail markets
are addressed by the EC.
3. Principles-based regulation and the retail markets
Closely associated with the identification of retail market outcomes,
principles-based regulation has become one of the more striking features
of the EC retail market regime. It applies in particular to the regulation of
distribution/advice (chapter 4) and of disclosure (chapter 5).
Principles-based regulation469 has a number of characterizations.470 It
typically involves: the articulation of regulatory objectives and outcomes
through high-level principles which are supported, where necessary, by
rules but also by guidance; a commitment to paring back unnecessary or
ambiguous rules; a focus on the achievement of outcomes;471 and better
engagement by industry and senior management with the delivery of
outcomes.472
Prior to the financial crisis, principles-based regulation had become
somewhat fashionable in regulatory design. The FSA was the standardbearer with its ‘more-principles-based’ regulation (MPBR) strategy.473 But
principles-based regulation became popular internationally,474 even being
467
468
469
470
471
472
473
474
European Commission, Green Paper on Retail Financial Services, pp. 2–3.
N. Moloney, EC Securities Regulation (2nd edn, Oxford: Oxford University Press, 2008),
pp. 1095–7.
This discussion of a complex area is necessarily brief. See, for example, J. Black, ‘Forms
and Paradoxes of Principles-Based Regulation’ (2008) 2 Capital Markets Law Journal
425; S. Schwarcz, The Principles Paradox (2008), ssrn abstractid=1121454; C. Ford, ‘New
Governance, Compliance, and Principles-Based Securities Regulation’ (2008) 45 American
Business Law Journal 1; and L. Cunningham, A Prescription to Retire the Rhetoric of
‘Principles-Based Systems’ in Corporate Law, Securities Regulation, and Accounting (2007),
ssrn abstractid=970646.
E.g. D. Kershaw, ‘Evading Enron: Taking Principles Too Seriously in Accounting Regulation’ (2005) 68 Modern Law Review 594.
J. Black, M. Hopper and C. Band, ‘Making a Success of Principles-Based Regulation’ (2007)
1 Law and Financial Markets Review 191.
Ford, ‘New Governance’.
FSA, Principles-Based Regulation: Focusing on the Outcomes That Matter (2007).
E.g. the adoption of a principles-based approach by the Japanese Financial Services Agency:
Financial Services Agency, The Principles in the Financial Services Industry (2008), available
how to intervene on the retail markets?
109
associated with international regulatory competitiveness.475 The financial
crisis has seen principles-based regulation recede from the regulatory
scene, amidst concerns that it led to a prejudicially light-touch supervisory style.476 The 2009 Turner Review has committed the FSA to more
intervention in the wholesale securities and banking markets in particular, significantly less reliance on market discipline, and more intrusive
supervision. Although the Review does not focus directly on principlesbased regulation, it is associated with a withdrawal from principles-based
regulation.477 But the FSA has not rejected principles-based regulation.
While it has acknowledged its limitations, the FSA appears committed
to moving from prescriptive rules to a higher level of articulation of
what the FSA expects of firms and to deterring ‘box-ticking’.478 It appears
concerned, however, to recharacterize ‘principles-based regulation’, with
its connotations of lighter touch supervision, as ‘outcomes-based regulation’ and to emphasize that regulation cannot operate on principles
alone.479 The financial crisis has also significantly strengthened the FSA’s
supervisory approach to principles and to the monitoring of outcomes,
with its Supervisory Enhancement Programme and its ‘intensive supervision’ model. But the basic commitment, in terms of regulatory design,
to regulatory principles appears to remain in place.480 Principles may also
provide a way for capturing the severe complexity risk which the crisis
has exposed.481 It may therefore be too early to abandon principles-based
475
476
477
478
479
480
481
via www.fsa.go.jp. In the EC, the Dutch AFM, for example, follows a principles-based
approach: AFM, Policy and Priorities for the 2007–2009 Period (2007), p. 15.
Cunningham, Prescription, pp. 55–62. The Paulson Report called for a more-principlesbased regulation approach to strengthen the weakening competitive position of the US
market: Interim Report on the Committee on Capital Market Regulation (2006) (‘Paulson
Report’), pp. 63–5. It suggested that ‘prescriptive rules should be fashioned, where sensible,
more in terms of outcomes, performance and results rather than inputs and mandated
processes’ (p. 8).
The failure of Northern Rock led to criticisms of the FSA’s reliance on principles-based
regulation. House of Commons, Treasury Committee, The Run on the Rock: Fifth Report
of Session 2007–2008 (2008).
P. Thal Larsen, ‘FSA Faces Fight to Regain Global Reputation’, Financial Times, 19 March
2009, p. 3, suggesting that the Review ‘provides a clear break with the FSA’s previous
philosophy of principles-based regulation’.
Speech by FSA Chief Executive Sants on ‘Delivering Intensive Supervision and Credible
Deterrence’, 12 March 2009, available via www.fsa.gov.uk/Pages/Library/index.shtml.
Ibid.
The emerging conduct-of-business regime for banking is based on a principles-based
model: Consultation Paper No. 08/19.
Schwarcz, Complexity, pp. 65–6, but warning of the need for common agreement on what
principles mean.
110
designing a retail investor protection regime
regulation, although principles are likely to be accompanied by significantly more intrusive supervision. Certainly, the EC retail market rulebook contains a number of principles-based requirements. While some
concerns have been raised as to principles-based regulation,482 the Parliament, at least, appears convinced of its flexibility benefits.483 A recasting
of the MiFID regime also seems very unlikely given current regulatory and
supervisory strain.
Principles-based regulatory design has benefits in the retail market
where the risks of regulatory intervention are significant and the outcomes sought are ambitious. Broad-based principles484 may focus regulators more closely on the achievement of core regulatory objectives485 and
reduce the risks of regulatory capture.486 Principles can capture innovation. The FSA’s application of MiFID’s principles-based rules to wraps
and platforms has been welcomed.487 MiFID’s disclosure and distribution
principles may also provide a basis for managing the cross-sector risks of
substitute products.488
Principles-based regulation promises much in terms of better firm compliance, the mitigation of ‘tick-the-box’ practices,489 and thus the achievement of stronger retail market outcomes ‘in action’.490 The FSA has, for
example, linked MPBR to a series of stronger consumer outcomes including a more innovative and competitive financial services industry, more
efficient markets and firms better attuned to consumers’ needs.491 If firms
are required to engage with how to achieve high-level outcomes in their
482
483
484
485
486
487
488
490
J. William, B. Sherwod and S. Scholtes, ‘Queues Outside Bank Damaged Case for LightTouch Regulation’, Financial Times, 21 January 2008, p. 1; and Clifford Chance, PrinciplesBased Regulation – Problems of Uncertainty (2007), p. 2.
European Parliament, Resolution with Recommendations to the Commission on Hedge Funds
and Private Equity (P6–TA(2008)0425, 2008), suggesting, at the height of the autumn
2008 market turbulence, that principles-based regulation provided the flexibility needed
in financial market regulation.
An extensive scholarship addresses the nature of principles and rules and considers the
related certainty, flexibility and effectiveness issues. E.g. L. Kaplow, ‘Rules v. Principles.
An Economic Analysis’ (1992) 42 Duke Law Journal 557.
W. Bratton, ‘Enron, Sarbanes–Oxley, and Accounting: Rules versus Principles versus Rents’
(2003) 48 Villanova Law Review 1023, 1037.
P. Mahoney and C. Sanchirico, General and Specific Legal Rules (2004), ssrn
abstractid=566201.
FSA, Platforms and More Principles Based Regulation (Feedback Statement No. 08/11,
2008), pp. 6 and 10.
See further ch. 4. 489 E.g. Kershaw, ‘Evading Enron’, 596.
FSA, Focusing on the Outcomes That Matter, p. 6. 491 Ibid., pp. 2 and 7.
how to intervene on the retail markets?
111
particular business environments, the potential exists for substantive compliance and investor welfare to improve; this process may also lead to better
firm ownership of the compliance process.492 Allowing greater innovation
by firms may also strengthen investor welfare. As discussed in chapter 5,
MiFID’s principles-based approach has led to significantly less prescription in retail market disclosures in the UK market, and more room for
firm innovation, although the regime’s effectiveness is not yet clear. Better
investor outcomes may also be supported by stronger industry sustainability; a principles-based approach should lead to reduced regulatory costs
as firms can develop tailored responses to regulatory requirements. In the
EC context, principles can also mitigate centralization risks. Innovative
supervisory practices in support of the achievement of outcomes may
also follow. The FSA’s high-level Principles for Business, and particularly
Principle 6 on fair treatment,493 underpin its flagship ‘law in action’ TCF
strategy.494
But principles-based regulation is not without risks, particularly in
the EC context. Effective principles-based regulation is not a proxy for
thinner or lighter rules. It operates on a continuum from regulation to
supervision and to enforcement; its different elements are connected by
the need to deliver clearly identified outcomes. This demands sophisticated
regulatory design and supervision. But there was little discussion of what
principles-based regulation involves during MiFID discussions, although
the EC is not alone in this regard.495 While principles-based regulation
has been associated with the Commission’s Better Regulation agenda,496 its
492
493
494
495
496
Ford, ‘New Governance’.
Principle 6 (fair treatment) requires that a firm must pay due regard to the interests of its
customers and treat them fairly. Principle 7 (clear disclosure) requires that a firm must pay
due regard to the information needs of its clients and communicate information in a way
which is clear, fair and not misleading. Other key retail market principles include Principle
9 on suitability and Principle 8 on conflicts of interests. The other principles, all of which
impact directly or indirectly on the retail markets, cover integrity (Principle 1), acting
with skill, care and diligence (Principle 2), management and control systems (Principle
4), financial prudence and financial resources (Principle 4), market conduct (Principle 5),
client assets (Principle 10) and the firm’s relationship with regulators (Principle 11).
See further ch. 4.
E.g. I. MacNeill, ‘The Evolution of Regulatory Enforcement Action in the UK Capital
Markets: A Case of “Less Is More”’? (2007) 2 Capital Markets Law Journal 345, critiquing
the FSA’s failure to assess the costs and benefits of more-principles-based regulation.
Commissioner McCreevy, Speech on ‘Regulators: Help or Hindrance’, International
Corporate Governance Network, 6 July 2007, available via http://europa.eu/rapid/
searchAction.do.
112
designing a retail investor protection regime
adoption seems to have been driven by exhaustion with the FSAP497 rather
than by a reasoned assessment of its risks and benefits and an appreciation
of what it requires.
As a result, investor welfare may be prejudiced by MiFID’s placing of
firm judgment and firm responsibility to achieve outcomes at the heart
of its pivotal disclosure and advice regime. The potential for firm/investor
incentive misalignment is already considerable; high-level principles,
unless carefully policed, may provide flawed incentives for firms to
neglect typically costly investor-facing procedures in the prevailing
difficult market conditions.498 The FSA’s FSCP has highlighted the risks
of placing significant emphasis on a firm’s judgment, and has called for
a review of the new model.499 The risks of excessive discretion can be
managed with clear guidance on what is expected from firms, robust
supervision and ex post enforcement. Under the TCF initiative, for
example, the FSA has deployed an arsenal of weapons to drive firm
compliance; but even it has struggled.500 But the risks may be considerable
on a pan-EC basis given limited supervisory experience and resource
strain.
In practice, guidance is strongly associated with principles-based regulation and is necessary to ensure a common market understanding of
the relevant outcomes and how they might be achieved. The Commission
has published an innovative MiFID ‘Q and A’,501 as have CESR502 and
other European regulators.503 So too has the FSA,504 exercising its wide
497
498
499
500
502
503
504
Principles-based regulation has been related to ‘the legislative fatigue experienced by
Member States and industry’ and the Commission’s consequent concern to avoid overregulation: ESC, Minutes, 23 February 2005.
The FSA warned during the financial crisis that weaker economic conditions may lead
investment firms to focus on short-term business survival and to neglect retail market
conduct-of-business requirements: FSA, Financial Risk Outlook 2008, pp. 25 and 47.
FSCP, Annual Report 2006–2007, p. 3.
See further ch. 4. 501 European Commission, ‘Your Questions on MiFID’ website.
CESR. Questions and Answers on MiFID: Common Positions Agreed by CESR Members
(December 2008 version) (CESR/08-943, 2008).
The AMF has produced a MiFID Q and A, while CONSOB has produced guidance on the
MiFID inducements regime.
It has, at times, declined to provide guidance. It was, for example, reluctant to issue
guidance on the MiFID Level 2 Directive’s operational rules given that ‘it is for a firm’s
management to decide how best their firm might meet [MiFID] requirements and it is
more appropriate for a firm to discuss issues or concerns bilaterally with its supervisors’:
FSA, Organisational Systems and Controls: Common Platform for Firms: Feedback (Policy
Statement No. 06/13, 2006), p. 4.
how to intervene on the retail markets?
113
discretion to adopt guidance,505 particularly in those areas where MiFID’s
rules have brought significant change.506 It has also clarified the status
of FSA guidance507 and of the industry guidance508 which has become
a feature of the MiFID landscape.509 But this proliferation of guidance
carries risks. Regulators may use ‘softer’ measures to reverse-engineer into
prescription without the checks and balances imposed on formal lawmaking. The FSA experience points to an exponential increase in quasiprescription through softer measures, including TCF progress reports,
case studies, speeches, and examples of best practice which are not subject to the formalities of FSA rule-making510 but which nonetheless have
drilled deep into firms’ practices. Retail investors are unlikely to be aware
of the risks which arise from the voluntary nature of guidance.511 The
retail interest will also not be well served by a more opaque regulatory
environment in which softer quasi-regulation proliferates and becomes
less readily available512 and which may prejudice the achievement of key
MiFID outcomes.513 Neither will it be well served by the heightened risk
of retail investor exclusion from the guidance-setting process (chapter 7).
505
506
507
508
509
510
511
512
513
FSMA, sect. 157. Guidance can be adopted within the FSA Handbook, accompanied
by supporting materials (FSA, Confirmation of Industry Guidance (Policy Statement No.
07/16, 2007), p. 4), and take the form of separate regulatory guides (e.g. Regulatory Guide
on the Application of TCF Principles to Product Providers: Regulatory Guide, annexed to
FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers
(Policy Statement No. 07/11, 2007) (see further ch. 3).
E.g. its guidance on the new appropriateness regime: FSA, Reforming Conduct of Business
Regulation (Policy Statement No. 07/6, 2007), pp. 57–61; and COBS 10.2.5–COBS 10.2.8.
FSA, Reader’s Guide: An Introduction to the FSA Handbook, p. 24.
Where industry guidance has been through the FSA’s confirmation process, firms which
follow it are regarded as complying with the relevant rules, but failure to comply is not
treated as indicating a rule breach as, according to the FSA, in many cases, there will be
more than one way to comply: Policy Statement No. 07/16, p. 7.
E.g. MiFID Connect, Information Memorandum on the Application of the Conflicts of Interest
Requirements under the FSA Rules Implementing MiFID and the CRD in the UK (2007);
and MiFID Connect, Guideline on the Application of the Suitability and Appropriateness
Requirements under the FSA Rules Implementing MiFID in the UK (2007).
FSMA imposes a number of requirements on FSA rule-making (sects. 152–156), including
impact assessment requirements.
FSA, FSA Confirmation of Industry Guidance (Discussion Paper No. 06/5, 2006), p. 17.
M. Hopper and J. Stainsby, ‘Pause for Thought: The FSA Needs to Decide What Status It
Intends to Ascribe to Industry Guidance’ (2007) 26(1) International Financial Law Review
40.
E.g. Black et al., ‘Making a Success’, highlighting the risks as including prejudice to certainty,
a proliferation of interpretive guidance, a blurring of the distinction between standards
and best practice, and supervisory and regulatory uncertainty.
114
designing a retail investor protection regime
Principles-based regulation also poses a considerable challenge to the
EC’s currently networked supervision model514 and to often inexperienced and ill-equipped supervisors. Successful principles-based regulation
requires a fundamental reconsideration of how supervision is carried out,
how the regulator communicates with the industry, and how firms can
legitimately protect themselves against supervisory action; failing which,
the ‘principles paradox’ arises.515 Principles-based regulation may also not
be sufficiently detailed to support relatively inexperienced supervisors in
dealing with complex retail market risks. While more established supervisors have a wealth of experience on which they can draw in applying MiFID,
or on which to base ‘Article 4’ applications for more detailed rules, others
will be required to rely heavily on MiFID’s core principles. The advanced
technology developed by the FSA in this area certainly underlines the considerable resources, experience and expertise required to deliver results
under a principles-based model and the challenges it poses in a pan-EC
context.
4. Evidence-based policy formation and rule-making
Effective regulatory risk management and stronger achievement of retail
market objectives is more likely when intervention is based on evidence.516
It is not new to call for testing;517 Coase’s seminal examination of the
nature of government intervention and of the management of social costs
called for the impact of rules on actors’ behaviour to be examined.518 The
514
515
516
517
518
The financial crisis is likely to lead to significant reforms to the supervisory structure
(chs. 7 and 8).
Schwarcz, Principles Paradox, suggesting that, while principles-based regulation can
achieve normative goals more effectively than rules, a regulated actor who faces unpredictable liability is likely to act as if it were subject to a rule, even where the rule is
unintended.
In a recent example, in the context of the FSA’s RDR, the FSA’s FSCP challenged the FSA’s
assumption that retail investors would not be willing to pay for higher-cost independent
investment advice, particularly where appropriate education was made available, and
rejected the FSA’s related assumption that the advice regime be segmented according to
the level of complexity and cost of the investment advice required as overly simplistic:
Response to a Review of Retail Distribution (2007), p. 10.
Calls for better data collection by the SEC are a regular feature of US investor protection
scholarship, for example, D. Langevoort, The SEC as a Lawmaker: Choices about Investor
Protection in the Face of Uncertainty (2006), ssrn abstractid=947510, arguing that the SEC
has ‘never shown much interest’ in whether disclosure can lead to better decision-making
(p. 20).
J. Coase, ‘Problems of Social Cost’ (1960) 3 Journal of Law and Economics 1. The Coasian
efficiency model accordingly shares a common heritage with behavioural finance although
how to intervene on the retail markets?
115
stakes have, however, become significantly higher with the policy concern to promote stronger engagement and as the extent to which investor
behaviour diverges from rationality becomes clear. Principles-based regulation also demands evidence. Supervisory and judicial determinations519
as to whether or not firm communications are ‘misleading’ or investment
firms act ‘fairly’ (MiFID, Article 19(1) and (2)) must be informed by
some evidence as to how investors behave. The financial crisis has also
exposed the need for better retail market research. The crisis has highlighted the serious systemic risks which flow from failure to recognize
the link between wider macro-economic policy (notably low interest rates
leading to an injection of funds into the financial system) and market
reaction (the catastrophic search for yield and a recycling of debt from
the banking sector into the securities market). But retail investors have
also formed part of this dynamic, investing more heavily in higher yield
alternative investments and structured products520 and then withdrawing
into capital-protected structured products. Regulatory policy with serious
ambitions in the retail markets must stand ready to identify and respond to
shifts in investment patterns. Without evidence, regulators will not be able
to capture emerging weaknesses in, for example, execution-only/advicefree regimes when new products begin to press heavily on the boundaries
of investor competence.
Until recently, hard evidence on investor decision-making has been
limited, partly given the rationality assumption but also given the difficulties in gathering data.521 But change is underway. Industry efforts
are intensifying. US research, for example, is being spearheaded by the
NASD (now FINRA),522 while the powerful Investment Company Institute has examined mutual fund disclosures ‘in action’.523 Demand-side
perceptions of intermediaries and of fair treatment have been examined
by the UK insurance industry.524 The 2006 call from the President of the
American Finance Association for economists to focus more closely on
519
520
522
523
524
it diverges from it with its rationality assumptions: Arlen, ‘Future of Behavioral Economics
Analysis’, 1765–6.
In Gut Springenheide GmbH [1998] ECR I-4657 (Case C-210/96), the Court noted that
national courts were not prohibited from taking into account consumer research polls or
experts’ judgments when assessing whether or not consumers were misled where there
was a particular difficulty in assessing the misleading nature of the communication.
FSA Financial Risk Outlook 2005, p. 86. 521 Campbell, ‘Household Finance’, p. 1557.
Its 2003 investor literacy study was the first national US study of its kind.
E.g. Investment Company Institute, Understanding Investor Preferences for Mutual Fund
Information (2006).
The ABI’s Customer Impact Scheme initiative includes annual assessments of consumers’
perceptions of how they are treated.
116
designing a retail investor protection regime
the dynamics of household investment525 also reflects growing academic
interest in household financial decision-making.526
Regulators are also engaging in large-scale efforts to understand investor
behaviour527 and to test regulation, particularly disclosure rules.528 Leading recent examples include the Canadian Deaves Report, the SEC’s recent
Rand Report on investment advice and brokerage, the AMF’s 2004 study
of French financial literacy and its regular research into retail market
trends,529 and the FSA’s studies of financial capability. The latter’s extensive research also includes efforts to understand the key ‘life events’ which
trigger interaction with financial services, to quantify the impact of reforms
to distribution and advice,530 to understand the retail investment products
market,531 and to track retail investment patterns.532
But the EC’s post-FSAP rule base was developed without evidence
on investor behaviour533 and without evidence on the structure of
the retail market. Given the Commission resources expended on Eurobarometer, which has examined financial services but could be used
more intensively,534 it does not seem unreasonable that a retail investor
index be constructed which would regularly gauge investor competence,
experience and investment attitudes.535 Although the 2007 BME Report
525
526
527
528
529
530
531
532
533
534
535
Campbell, ‘Household Finance’, suggesting that ‘the possibility that household finance
may be able to improve welfare is an inspiring one’.
R. Bluethgen, A. Gintschel, A. Hackethal and A. Mueller, Financial Advice and Individual
Investors’ Portfolios (2008), ssrn abstractid=968197.
The Australian regulator, ASIC, for example, has highlighted the importance of regulatory
understanding of what consumers of products are doing, what they are thinking, and how
they are behaving: Cooper, Retail Investors.
See further ch. 5.
AMF, L’´education financi`ere des Franc¸ais (summarized in French Savers) and its regular
Risks and Trends Mapping for Financial Markets and Retail Savings reports.
A series of studies were undertaken in relation to the RDR.
E.g. Oxera, Towards Evaluating Consumer Outcomes in the Retail Investment Products
Markets: A Methodology: Prepared for the Financial Services Authority (2008).
Including through its annual Financial Risk Outlook and its Retail Investments Product
Sales Data (PSD) Trends Report.
For an early criticism of this failure, see FIN-USE, User Perspective, p. 16.
E.g. European Commission, Special Eurobarometer No. 230; Special Eurobarometer No. 202;
and Eurobarometer 2003:5 Public Opinion in the Candidate Countries: Financial Services
and Consumer Protection: Summary Report (2004). They provide some limited evidence
about investor behaviour and sentiment on a pan-EC scale, particularly with respect to
confidence in dispute resolution (low), satisfaction with disclosure (low) and perception
of marketing by financial institutions (often seen as aggressive). The 2009 ‘crisis Eurobarometer’, however, did not address investor decision-making: Standard Eurobarometer
(EB71), Europeans and the Economic Crisis (2009).
An Investor Index project has been developed for the Canadian market: Black, Involving
Consumers, pp. 34–5.
how to intervene on the retail markets?
117
marks an important staging post, it is limited and largely based on secondary sources. Tests of investor behaviour are complex and expensive.
Questionnaires can be unreliable, proprietary data-sets can be limited and
reliable information hard to come by.536 Regulators, despite the resources
they can wield, are not immune from criticism; the FSA’s strenuous efforts
have, for example, been criticized as being overly general.537 But CESR provides a vehicle through which national initiatives can be collated, priorities
for evidence-gathering established, and experience shared;538 it is increasingly probing the structure of the retail markets.539 The FIN-NET dispute
resolution mechanism (chapter 8) provides another potentially important
resource on retail market behaviour in that analysis of the major types
of complaint which recur across the Member States could usefully be
integrated into the law-making process.
Some signs augur well. The Commission’s 2005 White Paper on postFSAP policy included a commitment to evidence-based policy-making,
based on wide consultation and impact assessment,540 and a commitment
to ex post assessment.541 New rules are being subject to ex ante impact
assessment testing, best illustrated by the extensive efforts expended on
the UCITS Key Investor Information model (chapter 5). An extensive panEC study (the 2008 Optem Report) has been carried out on consumer
reaction to a range of financial services disclosure, including investment
disclosure.542 The influence of EC consumer policy may also come to bear.
SANCO, the Directorate General for Health and Consumer Protection,
appears to have expended considerably more resources on research than
the Internal Market Directorate General, which is responsible for financial
services.543 SANCO is concerned to develop a ‘richer understanding of
536
537
538
539
540
541
542
543
Campbell, ‘Household Finance’, 1555–8.
National Consumer Council, Financial Capability: The NCC’s Response to the Treasury Consultation – Financial Capability: The Government’s Long-Term Approach (2007),
pp. 11–13.
CESR’s potential for acting as a clearing-house can be seen in its 2006 Factbook: CESR,
The European Single Market in Securities in 2006: A Factbook on Markets and Supervision
(2006).
E.g. CESR, Call for Evidence on UCITS Distribution (2007) (CESR/07-205, 2007).
European Commission, White Paper on Financial Services Policy, p. 4.
Ibid., p. 6. The Commission set 2009 as the deadline for a full legal and economic assessment
of the FSAP.
Optem Report. See further ch. 5.
Its website states that ‘[r]eliable and up-to-date information (quantitative and qualitative)
is essential for better policy-making . . . It is a cornerstone of Consumer Policy Strategy.
Convincing policy-makers and stakeholders of consumer concerns and demands depends
on a clear and defined “problem statement” and a fair and balanced assessment of all the
impacts.’
118
designing a retail investor protection regime
consumer behaviour [and] to understand how rational consumers are in
practice’.544 Notably, the 2008 Optem Study took place under its aegis, and
it has also developed a Consumer Scoreboard to assess the performance of
consumer markets.545 But the crisis did not lead to greater efforts to understand investor behaviour. By contrast, the proposed new US Consumer
Financial Protection Agency will be charged with evidence-gathering.
5. Controlling risk-taking and segmentation techniques
The risks of regulation may also be contained, and the achievement of retail
market objectives supported, by investor segmentation (or what might be
called ‘investor regulation’546 ) strategies which reflect different levels of
investor experience and sophistication. Segmentation can be restrictive
and protect vulnerable investors from excessive risk. Professor Choi’s oftcited proposal to restrict unsophisticated retail investors to passive index
funds is an elegant, if extreme, articulation of segmentation.547 But it
has resonances in the decisions regularly taken by regulators as to which
investments can be marketed to the public548 and with the restrictions
placed on the products which can be sold execution-only. But, where it
allows investors some degree of freedom in moving between segments,
segmentation can also accommodate growing levels of empowerment and
competence and mitigate the risks of over- or poor regulation. Segmentation also reflects a concern not to impose unwarranted regulatory costs on
the wholesale sector,549 and not to obstruct innovation which may benefit
544
545
546
547
548
549
European Commission, Consumer Policy 2007–2013, p. 9.
European Commission, Communication on Monitoring Outcomes in the Single Market: The
Consumer Markets Scoreboard (COM (2008) 31), pp. 4–7.
T. Paredes, Hedge Funds and the SEC: Observations on the How and Why of Securities
Regulation (2007), ssrn abstractid=984450.
Choi, ‘Regulating Issuers Not Investors’.
Member State regulators generally restrict retail investor access to investment strategies
which are considered to be ‘too risky’ and/or ‘too complex’, particularly in the form
of hedge funds and private equity/venture capital funds: PwC Retailization Report, p. 7.
On hedge fund segmentation, see, for example, Report of the Alternative Investment
Expert Group, Managing, Servicing, and Marketing Hedge Funds in Europe (2006); IOSCO,
The Regulatory Environment for Hedge Funds: A Survey and Comparison (IOSCO, 2006);
and PricewaterhouseCoopers, The Regulation and Distribution of Hedge Funds in Europe
(2005), p. 5.
‘Sensible principles of good regulation, including efficiency, economy, and proportionality,
suggest that rules reflect the differing needs for protection, both in types and amount,
of various investors whose knowledge, sophistication and understanding varies’: Paulson
Report, p. 65.
how to intervene on the retail markets?
119
the retail markets, typically by lifting protections for particular categories
of investors.
Segmentation appears in EC investor protection policy. Under the
Prospectus Directive, an extensive range of securities offerings are
exempted from the requirement to publish an approved prospectus but
are closed to retail investors. The Directive’s many exemptions are broadly
designed to carve out the institutional market and include offers addressed
to ‘qualified investors’,550 as well as offers with denominations of at least
€50,000 or requiring consideration of at least €50,000 (Article 3(2)). But,
as befits a regime with strong empowerment overtones, the Prospectus
Directive allows private investors to ‘opt in’ to ‘qualified investor’ status, as
long as they meet certain conditions.551 This self-certification regime contrasts with MiFID, which subjects any ‘opt in’ decisions to investment firm
oversight. MiFID segmentation includes relaxations on the application
of MiFID’s cornerstone conduct-of-business regime for more sophisticated investors; its application is governed by whether the investor is a
retail investor,552 who benefits from the full range of protections, a professional investor,553 who may opt out of the retail protections, or an eligible
counterparty.554 When eligible persons seek to ‘opt in’ to professional
investor status,555 extensive classification and notification requirements
apply.556 In a tightening of the Prospectus Directive, its ‘self-certification’
550
551
552
553
554
555
556
‘Qualified investors’ include institutional and regulated actors (such as investment firms,
CISs and credit institutions), governmental and public bodies, and large companies
(Art. 2(1)(e)).
Two of the following criteria must be met: they have carried out transactions of a significant
size on securities markets at an average frequency of at least ten per quarter over the
previous four quarters; the investor’s portfolio exceeds €500,000; and the investor has
worked for at least one year in the financial sector in a professional position which
requires broad knowledge of securities investment (Art. 2(1)(e)(iv) and (2)).
Defined by default as a client who is not a professional client: Art. 4(1)(12).
A professional client is one who falls within the criteria specified in Annex II to the
Directive (MiFID, Art. 4(1)(11)) which reflects the Prospectus Directive.
The MiFID Level 2 Directive specifies how the different conduct-of-business rules apply
to the retail and professional sectors.
The firm must be satisfied that the client meets two of the following criteria: the client has
carried out transactions, in significant size, on the relevant market at an average frequency
of ten per quarter over the previous four quarters; the client’s investment portfolio exceeds
€500,000; and the client works or has worked in the financial sector for at least one
year in a professional position which required knowledge of the transactions or services
envisaged.
Any waiver of conduct-of-business protections is valid only where an adequate assessment
of the expertise, knowledge and experience of the client, undertaken by the investment firm,
gives reasonable assurance, in light of the nature of the transactions or services involved,
120
designing a retail investor protection regime
model is to be aligned to MiFID’s approach.557 MiFID segmentation also
includes restrictions on the products which can be sold execution-only.
Segmentation is also common in the UK regime. Only regulated CISs
(largely based on the EC UCITS product but also including domestic, regulated non-UCITS funds (NURS) and FSA-recognized overseas schemes
(including passporting UCITS)), for example, may be marketed to the
public.558 Non-regulated schemes may only be marketed to those who have
already invested in similar schemes559 or where suitability requirements
are met.560 Restricting retail market access to particular products, whether
through industry discipline or regulatory fiat, was also highlighted as an
appropriate response to retail market risks by France’s Delmas Report.561
Segmentation can be a problematic regulatory device and must be
carefully deployed. It is associated with troublesome regulatory determinations that certain products or markets are ‘too risky’ for direct retail
market access or as to the design of ‘appropriate’ retail market products. The restriction of MiFID’s execution-only regime to ‘non-complex’
products (Article 19(6)), and the exclusion of derivatives, for example,
risks imposing additional advice costs on the sale of products which may
deliver stronger returns and protect against general market risks. The line
between safe and risky products is also particularly difficult to draw,562
not least given the untested and often confused regulator assumptions as
to the degree of risk which investors should carry. Unintended effects may
follow; the segmentation by the Prospectus Directive of retail and professional markets has reduced retail market access to the debt markets (section III.6 below).563 Segmentation may also not take sufficient account of
557
558
559
560
561
562
563
that the client is capable of making his own investment decisions and understands the
risks.
European Commission, Background Document: Review of Directive 2003/71 (2009).
FSMA, Part XVII. See E. Lomnicka, The Financial Services and Markets Act: An Annotated
Guide (London: Sweet & Maxwell, 2002), pp. 375–445.
The combined effect of the marketing regime and the extensive product requirements
imposed on regulated schemes is that the CIS industry is divided into publicly offered
and heavily regulated funds, and private funds which are privately placed and largely
unregulated: Benjamin, Financial Law, p. 248.
Non-regulated CISs may be recommended to investors in the course of an advice relationship and where suitability requirements are met: COBS 4.12.
Delmas Report, pp. 25 and 30.
The Commission has warned that national experience across the EC suggests that ‘there is
no fully satisfactory basis’ for distinguishing between safe and risky products for the retail
markets: European Commission, Investment Funds White Paper, p. 13.
In the US market, some unease has been expressed as to the potential prejudice to retail
investors from the scale of the US private placement regime and the institutionalization
how to intervene on the retail markets?
121
institutional investor monitoring of traditionally riskier investments.564
While both the Prospectus and MiFID regimes allow retail investors to
progress to professional/qualified investor status, the stringency of the
conditions suggests that very few retail investors will be in a position to
make the transition – where they do, the risks could be considerable as
determinations of contributory negligence may follow.565
Conversely, segmentation can be a blunt instrument and fail to control
the sale of risky and complex products in the retail sector. Effective segmentation through product regulation is very difficult to achieve; the reach of
the UCITS III regime suggests considerable policy tolerance for the extent
to which the retail market should be allowed to take on risks. Segmentation
in the form of limitations on the assets which can be purchased through
execution-only channels is also of limited use if the regulatory regime for
the eligible products supports the proliferation of a vast range of complex
products.
Where segmentation is based on classifying investors, nuanced decisions
are required. It is difficult to choose appropriate proxies for sophistication,
competence and risk appetite; it is all the more so as regulators have only
recently embraced research into investor decision-making. Inadequate
proxies can mean that the investment freedom of more sophisticated
investors is curtailed566 but that affluent but unsophisticated investors
may be exposed to overly risky products without adequate protection.
Net worth, the easiest and most common proxy,567 might suggest that
564
565
566
567
of the securities markets: R. Karmel, Regulation by Exemption: The Changing Definition of
an Accredited Investor (2008), ssrn abstractid=1115409.
It has been suggested that the stringent regulation imposed on US mutual funds contributed to the growth of hedge funds and deprived retail investors of the opportunity
to invest alongside sophisticated investors who would carry the monitoring burden: P.
Mahoney, ‘The Development of Securities Law in the United States’ (2009) 47 Journal of
Accounting Research 325.
The English High Court has determined that an investor who opted to move from
‘private’ to ‘intermediate’ status under the FSA regime was contributorily negligent
with respect to spread-betting losses: J. Gray, ‘High Court Rules Customer Who Opted
from Private to Intermediate Customer Status to Have Been Contributorily Negligent
to His Spread Betting Losses’ (2008) 16 Journal of Financial Regulation and Compliance
414.
The FSA appeared concerned not to obstruct natural persons who were ‘qualified investors’
from investing in private placements under the prospectus regime in designing the qualified investor register and in providing for a self-certification regime: FSA, Implementation
of the Prospectus Directive (Policy Statement No. 05/7, 2005), p. 10.
Used, along with experience tests, in the EC regime.
122
designing a retail investor protection regime
wealthy investors making more substantial investments have greater incentives to monitor their investments. But it is not an effective proxy for
sophistication.568 Investor testing offers intriguing possibilities.569 But,
and aside from resource and design difficulties,570 it sits uneasily with the
wider empowerment and choice dynamic of the current policy debate.
The risks of blunt segmentation may be contained where the segmenting decision moves from the regulator and becomes the responsibility of
the adviser; suitability assessments can replace regulatory segmentation
determinations. Segmentation could also take the form of an industry
requirement that products and services be appropriately targeted. But the
UCITS product regime remains some considerable distance behind the
UK model which requires product producers to consider whether products respond to investors’ needs and abilities.571
6. Diversification
a) Diversification and the retail markets
The prevalence of general market risk, and the threat it poses to trusting and empowered investors, calls for a careful regulatory response if
retail market objectives are to be achieved. Effective diversification572 is
key to strong returns and to protecting investors against market risk.573
It may also provide some protection against issuer fraud risks.574 But it is
568
569
570
571
572
573
574
H. Parry, ‘Hedge Funds, Hot Markets, and the High Net Worth Investor: A Case for Greater
Protection’ (2001) 21 Northwestern Journal of International Business Law 703. The FSA
acknowledged during its wider range products review that a threshold-based approach,
based on net worth or investability criteria, would be based on ‘admittedly rough and
ready criteria’: FSA, Discussion Paper No. 05/3, pp. 27–8.
Choi, ‘Regulating Issuers Not Investors’. Notably, MiFID saw an attempt to introduce
investor testing with respect to the application of disclosure requirements: see further
ch. 5.
Although online tests are being used in practice by investment firms to assess whether
particular complex products are appropriate for investors as required under MiFID,
Art. 19(5): M. Vincent, ‘Private Clients Will Face Tests’, Financial Times, 30 October 2007,
p. 21.
See further ch. 3.
For a celebration of the benefits of diversification theory, including for ‘ordinary investors’,
see M. Rubinstein, ‘Markowitz’s “Portfolio Selection”: A Fifty Year Retrospective’ (2002)
57 Journal of Finance 1041.
E.g. FSA, Financial Risk Outlook 2005, p. 28.
F. Easterbrook and D. Fischel, ‘Optimal Damages in Securities Cases’ (1985) 52 University
of Chicago Law Review 611; R. Booth, ‘The End of Securities Fraud Class Action’ (2006)
29 Regulation 46; and, contra, E. Evans, ‘The Investor Compensation Fund’ (2007–8) 33
Journal of Corporation Law 223.
how to intervene on the retail markets?
123
regularly highlighted as a common retail investor weakness.575 Retail
investors display a strong home bias576 and exit investments inefficiently.577
As outlined in section II above, diversification within asset classes, particularly equity, is generally poor across the EC and there is a strong home bias.
Calls are frequently made for diversification to be incorporated into
investor education strategies.578 But diversification should not simply be
regarded in terms of financial literacy. A focus on diversification can
facilitate regulators in deciding on the extent to which regulation should
empower vulnerable investors and support easier access to the markets.
Failure to address diversification risks while promoting an empowerment
agenda also represents an abdication of responsibility to investors with
respect to market risk.579 Diversification should be integrated into regulation and supervision, including in the suitability sphere (chapter 4).
Diversification is, however, increasingly becoming associated with retail
market policy. Internationally, the post-Enron reform movement in the US
has been associated with the management of diversification risk,580 while
the SEC’s developing mutual recognition model has been linked to better retail investor diversification.581 The FSA has also become concerned
575
576
577
579
580
581
E.g. Campbell, ‘Household Finance’, 1570–1. Much of the evidence concerns poor asset
selection in US pension funds (e.g. Benartzi and Thaler, ‘Naive Diversification’). Poor
diversification has also been identified in US brokerage accounts (Jackson, ‘To What
Extent?’), while evidence from the US Federal Reserve suggests that almost 60 per cent of
individual investors surveyed hold stock in three or fewer companies and that approximately 35 per cent hold stock in only one company (Evans, ‘Investor Compensation Fund’,
234).
E.g. W. Goetzmann and K. Kumar, Equity Portfolio Diversification (2008), ssrn
abstractid=1081787; W. Bailey, A. Kumar and D. Ng, Foreign Investments of US Individual Investors: Causes and Consequences (2007), ssrn abstractid=633902; J. Coval and T.
Moskowitz, ‘Home Bias at Home: Local Equity Preference in Domestic Portfolios’ (1999)
54 Journal of Finance 2045; and K. Lewis, ‘Trying to Explain Home Bias in Equities and
Consumption’ (1997) 37 Journal of Economics Literature 571.
Calvet et al., ‘Fight or Flight’. 578 See further ch. 7.
ASIC has been urged to focus on diversification given in part that diversification is ‘modern
financial theory at its most practical for retail investors’: Erskine, Retail Investors, pp. 7
and 9.
Langevoort, Social Construction, p. 16; and Camerer et al., ‘Asymmetric Paternalism’,
1236 (many Enron employees had invested all or a significant proportion of their 401(k)
employee pensions in Enron shares). The Enron-related Pensions Right to Know Act,
which was not adopted, would have required 401(k) plan sponsors to advise participants
on the importance of diversification.
Jackson, ‘System of Selective Substitute Compliance’, 111; and Tafara and Peterson,
‘Blueprint’, 41. The SEC’s June 2007 Roundtable on Mutual Recognition also saw support for easier retail investor access to the international markets given the potential for
better diversification: SEC, Unofficial Transcript of the Roundtable Discussion on Mutual
Recognition (12 June 2002), p. 26 (comments by Karmel).
124
designing a retail investor protection regime
with diversification.582 Its 2005 review of retail investor access to widerrange products suggested that the regulated CIS regime583 did not support
wide choice and that a blanket prohibition on the public marketing of
unregulated CISs (mainly non-UCITS alternative investment schemes)
was restricting investors in developing their knowledge of investment
products584 and did not adequately support risk-taking and wider access to
diversification opportunities.585 The FSA ultimately supported an extension of the regulated product universe to allow non-UCITS regulated CISs
to invest 100 per cent of their assets in unregulated CISs (this allows the
public marketing of funds-of-hedge funds) in order to widen access to
the greater risk-taking and diversification opportunities represented by
these investments.586 Support of stronger retail market diversification can
also be implied from the FSA’s recent review of the listing rules which
apply to listed investment entities.587 The new approach liberalizes asset
allocation588 and eschews prescriptive asset allocation rules589 in favour
of a single-platform regime based on the exercise of board discretion and
disclosure. It is designed to facilitate the listing of investment entities
which pursue a wider range of strategies and more modern investment
techniques.590
582
583
585
586
587
588
589
590
Its review of financial capability, for example, addressed the importance of diversification
(Establishing a Baseline, p. 17).
See further ch. 1. 584 FSA, Discussion Paper No. 05/3, p. 23.
Thereby contrasting sharply with the SEC’s tendency to weigh investor protection far more
heavily than opportunity costs: J. Bethel and A. Ferrell, Policy Issues Raised by Structured
Products (2007), ssrn abstractid=941720, p. 29.
FSA, Funds of Alternative Investment Funds: Feedback on Consultation Paper 07/6 and
Further Consultation (Consultation Paper No. 08/4, 2008), pp. 5 and 6; and FSA, Press
Release, 22 February 2008 (FSA/PN/01(2008)), noting that the new regime would support
greater consumer choice and create better opportunities for risk diversification.
Including Implementation of the Transparency Directive/Investment Entities Listing Review
(Consultation Paper No. 06/4, 2004); Investment Entities Listing Review (Consultation
Paper No. 06/21, 2006) and Investment Entities Listing Review – Further Consultation
(Consultation Paper No. 07/12, 2007).
Consultation Paper No. 06/4, p. 61. The review was based on the premise that boards should
not be constrained in undertaking investments they believe are in shareholders’ interests
and should be permitted to adopt more sophisticated strategies.
The earlier regime imposed a 20 per cent limit on single issuer investments and segmented
the regime into five types of fund, including venture capital and property companies.
The new regime is designed to accommodate more modern investment techniques, as
well as private equity funds and single strategy hedge funds: FSA, Consultation Paper No.
06/21, pp. 4 and 8; Consultation Paper No. 07/12, p. 8; and FSA, Investment Entities Listing
Review – Feedback on CP 07/12 and Final Handbook text (Policy Statement No. 07/20,
2007), p. 3.
how to intervene on the retail markets?
125
b) A patchy commitment to diversification: public offers, UCITS
and the execution-only regime
While diversification has been highlighted in the EC policy debate,591 it is
pursued in a somewhat haphazard manner. More effective diversification
has regularly been associated with integration.592 The combined effect
of the Prospectus Directive, the E-Commerce Directive and the DMD
is that traditional securities as well as investment products, including
structured products, approved in one Member State, can now be marketed
across the EC. The Prospectus Directive’s standardization of disclosure
may also support stronger diversification practices, if investors accordingly
become more familiar with cross-border issuers,593 although disclosure’s
transformative abilities are limited.
But there is little evidence that a pan-EC retail market for primary
market offers has developed594 or of the Directive supporting stronger
diversification.595 Issuer resistance,596 given the attractions of private
placements, difficulties with the retail market summary prospectus,597
multiple opacities in the Directive,598 persistent retail investor difficulties
with disclosure and the costs of cross-border trading, all represent considerable obstacles to the development of a cross-border retail market.599
591
592
593
594
595
596
597
598
599
FSC Report, p. 20, noting household demand for diversified or less correlated asset classes.
E.g. European Commission, European Financial Integration Report 2007, p. 7 and European
Financial Integration Report 2008 (SEC (2009) 19), p. 6. The FSA’s Europe Economics
MiFID study also pointed to the reduction in diversification costs which MiFID could
generate: Europe Economics, The Benefits of MiFID: A Report for the Financial Services
Authority (2006).
T. Baums, Changing Patterns of Corporate Disclosure in Continental Europe: The Example
of Germany, ssrn abstractid=345020; and C. Villiers, Corporate Reporting and Company
Law (Cambridge: Cambridge University Press, 2006), p. 199.
E.g. ICMA, Response to CESR’s Consultation on the Supervisory Functioning of the Prospectus
Regime (2007), pp. 2 and 3; Sullivan and Cromwell, Response to CESR’s Consultation on
the Supervisory Functioning of the Prospectus Regime (2007); and CSES Report, p. 22.
CSES Report, pp. 18, 21 and 52, pointing to the still dominant home bias among retail
investors, and suggesting that better portfolio diversification for retail investors was not
among the Directive’s benefits.
E.g. P. Ondrej, ‘ICMA’s Response to CESR on the Prospectus Directive and the Regulation’,
ICMA Regulatory Policy Newsletters No. 5, April 2007, p. 2.
See further ch. 6.
Which have been the subject of three key reports: CSES Report; CESR, CESR’s Report on the
Supervisory Functioning of the Prospectus Directive and Regulation (CESR/07-225, 2007);
and ESME, Report on Directive 2003/71/EC (2007).
E.g. S. Revell and E. Cole, ‘Practical Issues Arising from the Implementation of the
Prospectus Directive – What Are the Equity Capital Markets Worrying About?’ (2006)
1 Capital Markets Law Journal 77; K. Craven, ‘Assessing the Impact of the Prospectus
126
designing a retail investor protection regime
These weaknesses are mitigated by MiFID’s liberalization of order execution which facilitates investor access to the securities of issuers listed
outside the investor’s domestic market. But third-country issuers face
significant obstacles in accessing the Community capital market,600 limiting retail market diversification opportunities, and trading costs remain
high.601
The UCITS regime is of central importance to effective diversification
in that most retail investors engage with the markets through products.
Effective diversification therefore often depends on product design. The
UCITS regime (chapter 3) supports stronger investor diversification given
the range of investments which a UCITS may make. But, as discussed in
chapter 3, products remain complex, are proliferating and can often perform poorly. UCITS diversification rules are limited and product providers
are not subject to any obligation to design products which are appropriate for the retail market. Distribution weaknesses and weak retail market
competition dynamics are also hampering the construction of a pan-EC
UCITS market; UCITS design is thus often closely related to long-standing
local market asset preferences and so is less effective in delivering real diversification.
Execution-only regimes play a key role in supporting investors in achieving low-cost diversification. MiFID’s Article 19(6) execution-only regime
applies to a wide range of identified instruments, including shares admitted to trading on a regulated market or on an equivalent third-country
market, bonds or other securitized debt (but excluding debt instruments
which embed a derivative and are accordingly ‘complex instruments’ outside the scope of Article 19(6)), UCITS units, money-market instruments
and other ‘non-complex instruments’. An instrument is ‘non-complex’
and eligible for execution-only sales where it is a non-derivative financial
instrument, is liquid and easily realizable and does not involve any actual
or potential liability for the client that exceeds the costs of acquiring the
instrument (MiFID Level 2 Directive, Article 38). Disclosure is also used to
govern the scope of the execution-only regime; ‘adequately comprehensive’
information on the instrument’s characteristics must be publicly available
and must be likely to be readily understood so as to enable the ‘average
600
601
Directive’, ICMA Regulatory Policy Newsletters No. 5, April 2007; E. Ferran, Cross-Border
Offers of Securities in the EU: The Standard Life Flotation (2006), ssrn abstractid=955252;
and Moloney, EC Securities Regulation, pp. 128–31.
E. Ferran, Building an EU Securities Market (Cambridge: Cambridge University Press,
2004), pp. 205–6.
See further ch. 6.
how to intervene on the retail markets?
127
retail client’ to make an informed judgment as to whether to enter into
a transaction in that instrument. The wide range of products which can
be sold execution-only and the reliance on disclosure implies a facilitative
approach to market access and to diversification opportunities.602
But there are difficulties with the regime. The exclusion of derivatives, which was strongly resisted by the industry during the level 2
negotiations,603 is problematic. Investors’ opportunities to manage risk
and diversify and their learning opportunities are limited by this broad
exclusion604 which reflects a traditional and paternalistic approach to
investor protection.605 MiFID acknowledges that some Member States
have developed active execution-only retail markets in derivatives and
that, in certain circumstances, the ‘appropriateness’ suitability test (which
would otherwise apply under MiFID Article 19(5) to the sale) is assumed
to be met.606 The industry may also be willing to reduce the costs of
the appropriateness test. Spread-betting products and contracts for differences (CFDs),607 which have enjoyed strong retail market growth in the
UK,608 come within MiFID’s scope609 but are complex products under
602
603
604
605
606
607
608
609
CESR’s advice (reflected in Art. 38) was designed to provide the necessary flexibility for
a wide range of existing and innovative financial instruments: CESR, Technical Advice
on Level 2 Implementing Measures on the First Set of Mandates Where the Deadline Was
Extended and the Second Set of Mandates: Markets in Financial Instruments Directive:
Feedback Statement (2005, CESR/05-291b) (‘Second Mandate Advice Feedback Statement’),
p. 26. Further guidance on the complex/non-complex distinction is being provided by the
Commission through its MiFID Q and A which takes a more conservative approach. The
Commission has suggested, for example, that warrants and convertible bonds are complex
products: European Commission, ‘Your Questions on MiFID’ website.
Second Mandate Advice Feedback Statement, p. 26.
Bethel and Ferrell caution against over-regulating derivative-based products given the
benefits they offer in terms of low transaction costs: Policy Issues, p. 23.
It has been suggested that MiFID ‘demonizes derivatives’ and adopts an ‘overly crude and
generalized’ approach: A. Knight, ‘MiFID’s Impact upon the Retail Investment Services
Markets’ in C. Skinner (ed.), The Future of Investing in Europe’s Markets after MiFID
(Chichester: John Wiley & Sons, 2007), p. 207.
MiFID Level 2 Directive, recital 59.
Spread-betting products and CFDs, which are developed by specialist firms, allow investors
to bet on price movements in the financial markets without taking delivery of the underlying assets: C. Brady and R. Ramyar, White Paper on Spread Betting (2007), pp. 9–10.
Annual growth rates of between 20 per cent and 26 per cent have been predicted: ibid.,
p. 11. The FSA has also reported strong retail activity in the spread-betting market: FSA,
Implementing MiFID’s Best Execution Requirements (Discussion Paper No. 06/3, 2006).
Under MiFID, Annex I, sect. C. The importance of MiFID’s application to this sector
is reflected in the series of questions on the Commission’s ‘Your Questions on MiFID’
website which ask whether CFDs come within its scope (the Commission has responded
128
designing a retail investor protection regime
Article 19(6).610 But, rather than retreat from the retail market, the industry response appears to have been to develop appropriateness questionnaires and tests.611
Nonetheless, the regime remains conceptually untidy, it is likely to
entrench local market preferences and it does not support investor learning. Neither does the exclusion of derivatives reflect the injection of derivatives into the UCITS III regime and the tacit acceptance that the retail
market should be exposed to opportunities to take on higher levels of
risk. UCITS do support diversified access to derivatives. But it is also the
case that the UCITS spectrum includes high-risk CISs designed for the
institutional sector but which can trickle down to the retail markets. These
products can be sold execution-only. The regime will appear all the more
clumsy if the level 2 requirements for ‘non-complex’ investments do not
adequately capture the potential liquidity, insolvency and transparency
risks of structured retail products,612 which became clear over the ‘credit
crunch’ and particularly with respect to the Lehman insolvency.613
b) Supporting access to different asset classes: the debt
markets example
The pursuit of retail market diversification demands nuanced decisions
as to how far regulatory policy should go in easing investor access to
different asset classes. Two notable examples arise from current EC policy:
the treatment of alternative investments (chapter 3); and the debt markets.
Bond investments can provide investors with relatively stable returns
and some protection against market risk.614 But they are sensitive to interest rate movements, are exposed to default risk (as the ‘credit crunch’ made
610
611
612
613
614
in the affirmative, unless the underlying instrument does not come within MiFID, such
as a contract which relates to a political or sports event).
Which has been confirmed by the Commission on its ‘Your Questions on MiFID’ website.
D. Thomas, ‘Regulation: The Day of the MiFID Approaches’, Financial Times, 28 September
2007, available via www.ft.com.
The mis-selling of precipice bonds in the UK, for example, saw the FSA express concern as
to the quality of disclosure in direct offer mailings: FSA, Press Release (FSA/PN/026/2003).
CESR has raised concerns as to whether the criteria according to which structured products
are determined to be ‘non-complex’ are adequate and is to prepare level 3 guidance: CESR,
The Lehman Brothers Default: An Assessment of the Market Impact (2009) (CESR/09-255,
2009), p. 3.
The autumn 2008 convulsions in world stock markets saw some support for bond investments in the media. E.g. H. Connon, ‘Don’t Put It under the Floorboards – There Are Still
Safer Places for Cash’, The Observer, 12 October 2008, Cash, p. 13.
how to intervene on the retail markets?
129
clear615 ) and emerging market and high-yield bonds can pose significant
risks.616 Retail investors are increasingly becoming exposed to the bond
markets,617 not least as governments improve the distribution of sovereign
bonds618 and following retail investor aversion to the equity markets in the
wake of the dotcom crash,619 and they are popular investments in some
parts of the EC market.620 Although the Commission appears to support
wider access to the debt markets,621 the EC’s approach to debt market
access has been quixotic.
The Prospectus Directive seems, albeit unintentionally, to have reduced
the retail debt market and so limited diversification opportunities.622
Issuers have avoided retail market offerings, as an approved prospectus is
not required for debt offerings with denominations of at least €50,000.623
Confusion over the application of prospectus requirements to the ‘retail
615
616
617
618
619
621
622
623
Dramatic inflows of retail investor funds into corporate bond funds in the UK, based on
falling prices as spreads widened and on expectations that prices would rise if the risk
premium eventually fell, raised some industry concern in early 2009 given higher default
risks: S. Johnson, ‘Bond “Hype” Causing Concern’, Financial Times, Fund Management
Supplement, 26 January 2009, p. 2.
F. Salmon, ‘Stop Selling Bonds to Retail Investors’ (2004) 35 Georgetown Journal of International Law 837.
IOSCO, Transparency of Corporate Bond Markets (IOSCO, 2004), p. 4. The 2007 IOSCO
prospectus standards for debt offerings reflect the increased participation of retail investors
in the debt markets: IOSCO, International Disclosure Principles for Cross-Border Offerings
and Listings of Debt Securities by Foreign Issuers (IOSCO, 2007), p. 1. In the US, the TRACE
reporting system shows that 65 per cent of the reported trades are below US$100,000 in
value and associated with retail investment: FSA, Trading Transparency in UK Secondary
Bond Markets (Discussion Paper No. 05/5, 2005), p. 14.
Initiatives to improve direct access by retail investors have been undertaken in Spain,
France, and the UK: BME Report, p. 109 (including the Private Investor’s Guide to Gilts
(2006), issued by the UK Debt Management Office).
FSA, Financial Risk Outlook 2006, p. 50. 620 See further ch. 1.
European Commission, Call for Evidence: Pre- and Post-Trade Transparency Provisions of
MiFID in Relation to Transactions in Classes of Financial Instruments Other Than Shares
(2006), p. 5.
ICMA reported that the ‘failure to create more investment opportunities’ was particularly
disappointing given growing demand for a pan-EC retail market in debt securities: ICMA,
Response to CESR’s Consultation on the Supervisory Functioning of the Prospectus Regime
(2007), p. 6.
CSES Report, suggesting that the exemption has led to a reduction in the retail debt
market from €147.4 billion (2003) to €97.6 billion (2007), with significant effects in the
traditionally large retail debt markets in France, Italy and Germany (DaimlerChrysler
has stopped issuing bonds below €50,000) (pp. 55–6, 59 and 62). ESME had earlier
reported that, while only 8 per cent of bonds listed in Stuttgart (a major debt venue) had
a denomination of €50,000 in 2005, this had risen to 42 per cent in 2006: ESME, Report
on Directive 2003/71/EC, p. 14.
130
designing a retail investor protection regime
cascades’ typically used to distribute private placements of debt securities
in the retail sector is also restricting retail access.624 It must be acknowledged that the Directive was negotiated in the cauldron of industry agitation and political compromise and that the Commission appears to be
responding to the debt market problem.625 But the Directive’s unintended
effects provide, nonetheless, an important lesson for future regulatory
design and suggest that diversification should be a guiding principle for
law-makers.
Retail market interests and diversification were more to the fore during
the Commission’s 2007–8 consultations on whether MiFID’s controversial equity-market trading transparency requirements should be extended
to the debt markets. Although wholesale market concerns dominated
(reflecting concerns as to damage to liquidity were transparency requirements imposed), the consultation process revealed considerable evidence
that bond-market transparency information cannot easily be accessed
by retail investors and that they have difficulties in accessing the bond
markets.626 But the promotion through transparency regulation of easier
access to the debt market is risky given the wider liquidity risk which
greater transparency poses. It is also risky as retail investor familiarity with
the debt markets varies very considerably across the EC.627 Retail market
diversification can also be achieved indirectly through the UCITS product
and exchange-traded funds.
FIN-USE, however, trenchantly supported a widening of investment
horizons beyond the equities markets and a ‘MiFID-like’ mandatory transparency regime.628 While the FSA accepted the possibility that enhanced
transparency rules might support easier retail access, it was less convinced
that ‘it had a role to promote retail participation as an end in itself’ although
624
625
626
627
628
CSES Report, pp. 62–3 and 64.
Its 2009 agenda for prospectus reform proposed that issuer choice of prospectus supervisor
be allowed for all non-equity offerings and that subsequent prospectuses not be required
at each stage of a placement of securities: European Commission, Background Document:
Review of Directive 2003/71.
Centre for Economic Policy Research (B. Biais, F. Declerck, J. Dow, R. Portes and E.-L.
von-Thadden), European Corporate Bond Markets: Transparency, Liquidity and Efficiency
(CEPR, 2006); CESR, Non Equity Market Transparency, Consultation Paper (CESR/07-284,
2007; and ESME, Non-Equity Market Transparency (2007).
See further ch. 1. The FSA’s FSCP warned that the large majority of UK retail consumers
would not necessarily appreciate bond market risks: FSCP, Response to FSA Discussion
Paper 05/5 (2005), p. 1.
FIN-USE, Response to Call for Evidence: Pre- and Post-Trade Transparency Provisions of
MiFID in Relation to Transactions in Classes of Financial Instruments Other Than Shares
(2006).
how to intervene on the retail markets?
131
it was concerned as to whether aspects of the bond markets’ operation
might deter retail involvement.629 It also found no hard evidence that
transparency difficulties were frustrating retail investor involvement;630
an interesting choice might have arisen had the evidence been different,
given earlier FSA support for the retail debt market during prospectus
regime reforms.631 In a very different market context,632 by contrast,633 a
CONSOB official suggested that, if higher transparency levels were to
reduce transaction costs, wider participation in the bond markets might
follow634 and CONSOB supported a harmonized regime. CESR, which
has adopted a retail market agenda (chapter 7), suggested that greater
retail participation in the bond markets might follow from an increase
in transparency levels.635 But it supported a market-driven solution to
transparency risks.
The high profile of retail-market-access difficulties during the consultation process and the implicit threat of intervention appears to have
prompted a self-regulatory response from the industry. The International
Capital Market Association (ICMA) adopted in September 2007 a Standard on bond market transparency which is designed to improve the quantity and accessibility of price and liquidity information for retail investors
concerning liquid and highly rated bonds.636 Industry investor education
629
630
631
632
633
634
635
636
FSA, Discussion Paper No. 05/5, pp. 5 and 7.
FSA, Trading Transparency in the UK Secondary Bond Markets (Feedback Statement
No. 06/4, 2006), pp. 22 and 24.
FSA, Implementation of the Prospectus Directive (Policy Statement No. 05/7, 2005), p. 14.
Bond investments are popular in Italy. See further ch. 1.
Support for retail market access was stronger in those markets where retail investors are
active. The Danish Shareholders’ Association (in their response to CESR’s consultation),
for example, argued that, if retail investors were persistently excluded from the bond markets, the Commission should intervene to ensure market access and access to transparency.
The Italian Banking Association similarly argued that limited transparency could seriously
hamper retail investors’ direct participation in the market: European Commission, Feedback Statement, Pre- and Post-Transparency Provisions of MiFID in Relation to Transactions
in Classes of Financial Instruments Other Than Shares (2006), p. 10.
C. Salini (Head of Markets and Economic Research Division – CONSOB), Contribution at ABI Conference on ‘Bond Markets in Italy: Transparency and Regulatory Issues’,
19 March 2007, available via www.consob.it, para. 1.1.
CESR, Response to the Commission on Non-Equities Transparency (CESR/07-284b, 2007)
(‘CESR Bond Market Advice’).
ICMA, European Financial Services Industry Standard of Good Practice on Bond Market Transparency for Retail Investors (2007). The ICMA regime supports ‘BondMarketPrices.com’ which provides free data on higher quality investment grade bonds with a
large issue size. Bond market transparency data is also provided by SIFMA through its
www.investinginbondsEurope.com site.
132
designing a retail investor protection regime
measures were also taken.637 The Commission’s final report on debt market transparency, delivered in April 2008,638 acknowledged some problems
with retail investor access to bond market prices but decided against regulatory intervention. While retail market transparency remained an ‘area of
potential concern’, it concluded that market participants were well placed
to enhance retail investor access to bond prices and ‘for the time being’
supported self-regulatory measures.639
The debt market access debate ultimately delivered a relatively nuanced
response to access and diversification risks. The commitment to industry
monitoring appears real. Following a series of difficulties in the debt markets over the ‘credit crunch’, including a contraction of liquidity, a widening of spreads, valuation difficulties and a lack of post-trade information,
CESR has reopened the transparency debate and asked whether greater
transparency would ease the market difficulties.640 But the consultation
also addresses retail market risks. While CESR still appears committed
to a self-regulatory solution, it is unhappy with the industry’s efforts to
promote retail market transparency and concerned as to delays in the data
provided, its limited coverage and a failure to provide trade-by-trade data.
It has called for the content and timing of the data supplied to be enhanced.
Member States also remain empowered to adopt retail market debt
market transparency rules (MiFID, recital 46). But the risks of a ‘one-sizefits-all’ approach, considerable given sharply diverging bond investment
patterns, are avoided; Italy’s adoption of a transparency regime in 2008,
which responds to its large retail market, can be accommodated under the
current approach.
The debt market issue also underlines the importance of framing the
regulatory question in the right way. Given the nascent state of the retail
markets and the availability of indirect bond investments, the key regulatory question seems to be whether investors are appropriately advised on
debt market risks, not whether transparency might support better access.
As the losses sustained by retail investors in the Parmalat corporate bond
collapse641 and the Argentine government bond default made clear, bond
637
638
639
640
641
See further ch. 7.
European Commission, Report on Non-Equities Market Transparency Pursuant to
Article 65(1) of Directive 2004/39/EC on Markets in Financial Instruments (2008).
Ibid., pp. 10 and 12–13.
CESR, Transparency of Corporate Bond, Structured Finance Product, and Credit Derivatives
Markets: Consultation Paper (CESR/08-1014, 2008).
The Parmalat scandal concerned a massive bankruptcy involving looting by controlling
shareholders (through off-balance sheet transactions via special purpose vehicles) and
how to intervene on the retail markets?
133
market risk to retail investors is often a function of conflict-of-interest642
and suitability risks in the advice relationship.643 Retail investors tend to
hold debt securities long-term and do not typically trade in these securities;
the initial investment advice relationship (where advice is taken) is therefore the critical point for targeted investor protection measures, not transparency information. Investor protection in the bond markets therefore
depends heavily on the effectiveness of MiFID’s suitability/appropriateness
and best execution regimes. It also depends on whether the execution-only
regime ensures that only non-complex debt instruments are sold without
advice; the MiFID advice regime may have what could be the salutary
effect of reducing sales of complex bonds and increasing sales of diversified UCITS bond schemes.644
642
643
644
failures in financial reporting which broke towards the end of 2003. Parmalat engaged in
a final and worthless €150 million bond issue, a substantial proportion of which flowed
to the retail sector: G. Ferrarini and P. Guidici, Financial Scandals and the Role of Private
Enforcement: The Parmalat Case (2005), ssrn abstractid=730403.
Conflict-of-interest management was a strong feature of the policy debate on Parmalat: for
example, European Commission, Preventing and Combating Financial Malpractice (2004)
(COM (2004) 611); and ESC, Minutes, 17 February 2004.
ESME, Non-Equity Market Transparency, p. 10; and CESR Bond Market Transparency
Advice, p. 15.
CESR Bond Market Advice, p. 14. Although bond schemes are popular in Southern Europe,
UK CIS bond investments are increasing. Between 2001 and 2004, unit trusts and openended investment companies increased their investments in UK corporate bonds from
£12.9 billion to £23 billion: FSA, Discussion Paper No. 05/5, p. 14.
3
Product regulation
I. Product regulation and the retail markets
1. The EC and product regulation
Retail investment products (sometimes termed ‘packaged products’1 ) can
take myriad forms. They include mutual funds or collective investment
schemes (CISs) which pool investor assets (whether held in a corporate or
other form and whether represented by a share or other unit), are managed
according to investment mandates and redeem investors’ investments on
demand (or are ‘open-ended’); these structures are the main concern of
EC product regulation. Investment trusts or companies which engage in
investment business and in which investors hold often listed shares, unitlinked insurance products and a burgeoning array of structured retail
investment products are also popular retail market products.2
Product design regulation, typically linked to the authorization of the
product for public marketing and so associated with segmentation-based
regulation, is one of the three arcs of retail market protection along with
the regulation of distribution and disclosure. Product regulation in the
EC regime is largely a function of the ‘UCITS’ regime which provides a
cross-border marketing passport for CISs in the form of UCITS and their
management companies.3 Major reforms in 2002 (the UCITS III reforms)
significantly increased the range of UCITS investable assets. The UCITS
IV reforms,4 currently in train, are designed to bring efficiencies to the
1
2
3
4
A term strongly associated with UK Financial Services Authority (FSA) regulation but which
the European Commission adopted in its April 2009 Communication which responded to
the substitute products debate: European Commission, Communication from the Commission to the European Parliament and the Council: Packaged Retail Investment Products (COM
(2009) 204).
Sect. IV below.
Council Directive 85/611/EEC of 20 December 1985 on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in
transferable securities, OJ 1985 No. L375/3.
The UCITS IV Proposal to reform and recast the UCITS regime has been through its
Parliamentary reading. References to the reform (the ‘UCITS Recast’ or ‘UCITS IV’) are
134
product regulation and the retail markets
135
UCITS market and to reform the UCITS disclosure regime (chapter 5).
But, and mitigating the harmonization risks, the EC product regime is by
no means monolithic, certainly by comparison with MiFID. Many different
forms of investment product are marketed and regulated domestically and
respond to local market preferences and regulatory requirements.5 But,
as discussed in section IV below, regulatory arbitrage risks, particularly
between heavily regulated UCITS and other products, are considerable.
The 1985 UCITS CIS regime was designed as a supply-side measure and
to support cross-border UCITS marketing; it was crafted long before the
retail market had impinged seriously on EC policy and regulation.6 The
2002 UCITS III reforms were also adopted without institutional engagement with retail market investments patterns, distribution and advice
risks, and the role of product regulation in supporting investment and
risk-taking.7 More recently, however, the UCITS regime has become closely
tied to EC retail market policy, the promotion of long-term savings8 and
the market engagement movement.9 The 2005 Commission Investment
Funds Green Paper identified the UCITS as part of the solution to the
5
6
7
8
9
to the European Parliament text: European Parliament, Legislative Resolution of 13 January
2009 on the Proposal for a Directive of the European Parliament and of the Council on the
co-ordination of laws, regulations and administrative provisions relating to undertakings for
collective investment in transferable securities (2009) (P6 TA-PROV(2009)0012, 2009).
Non-UCITS domestic regulation tends to be diverse. It ranges from no recognition for nonUCITS schemes (Poland) to detailed local regulation (e.g. Germany, Italy, Luxembourg and
Ireland): PricewaterhouseCoopers, The Retailisation of Non-Harmonised Investment Funds
in the European Union (2008) (‘2008 PwC Retailization Report’), p. 7. Ch. 1 outlines the UK
domestic regime.
J. Gray, ‘Personal Finance and Corporate Governance: The Missing Link: Product Regulation
and Policy Conflict’ (2004) 4 Journal of Corporate Law Studies 187, 201.
The Commission’s proposals (COM (93) 37, COM (94) 329 and COM (98) 449) do not
grapple with UCITS policy as a mechanism for promoting investment. ECOSOC only
tentatively suggested that the UCITS regime should support ‘small investors’ in achieving
diversification (1999 OJ No. C116/44, paras. 1.1 and 3.6.5), while the European Parliament (A4-0232/99, 1999) suggested the regime could ‘inspir[e] confidence in listed shares
and bonds’ (Opinion of the Committee on Economic and Monetary Affairs, para. 1). The
Council was primarily concerned with market integration and cross-border UCITS marketing: Council Common Position (2001 OJ No. C297/35), Statement of Reasons, II, Aim
of Proposal.
Commissioner McCreevy has highlighted the potential of CISs as the ‘vehicle of choice
for private retirement provisioning’: Speech to Commission Hearing on Investment Funds,
13 October 2005, available via http://europa.eu/rapid/searchAction.do.
‘If widespread retail investment in investment funds is to be encouraged, then a sound regulatory framework is needed’: Commissioner McCreevy, Speech on ‘Retail Financial Services
and the Consumer’, 26 January 2005, available via http://europa.eu/rapid/searchAction.do.
136
product regulation
EC’s pension deficit,10 while the 2006 White Paper characterized CISs in
benign terms as providing ‘small investors’ with access to professionally
managed and diversified investments.11 Empowerment and responsibilization themes can be identified in the policy and industry rhetoric, which
often characterizes the UCITS as a ‘household product’ with risk levels appropriate for retail investors,12 and in the related ‘branding’ of
the UCITS product,13 which enjoys some retail stakeholder support.14
The European asset management industry has frequently argued that the
industry can foster financial independence and generate better returns for
retirement provisioning.15
Reflecting a wider institutionalization of the retail markets and a shift
from direct investments,16 CIS investments (dominated by UCITS) rank
ahead of direct investments in popularity across the EC, although behind
bank deposits and, significantly for regulatory arbitrage risks, insurancerelated investment products.17 The industry is, nonetheless, significant.
10
11
12
13
14
15
16
17
European Commission, Green Paper on the Enhancement of the EU Framework for Investment
Funds (COM (2005) 314) (‘Investment Funds Green Paper’), pp. 3 and 16.
European Commission, White Paper on Enhancing the Single Market Framework for Investment Funds (COM (2006) 686) (‘Investment Funds White Paper’), p. 2.
Deutsche Bank Research, EU Asset Management (EU Monitor No. 37, 2006), p. 6, describing
the UCITS as an investment with a degree of risk and complexity that ordinary investors
can be expected to bear.
Well illustrated by the concern of the European Fund and Asset Management Association
(EFAMA) that the Madoff scandal might damage the UCITS brand and its assertion
that the UCITS Directive provided extensive investor protection: EFAMA, Press Release,
15 January 2009.
The UK FSA’s Financial Services Consumer Panel (FSCP) has suggested that, with respect
to UCITS, ‘product regulation has been a clear success’: FSCP, Response to the FSA on
DP05/3 Wider Range Retail Investment Products (2005), p. 3.
An early 2009 industry report, for example, called for the UCITS to become the primary
vehicle for retirement savings: P. Skypala, ‘Squabbling over Pan-European Funds’, Financial
Times, Fund Management Supplement, 9 February 2009, p. 6.
E.g. W. Gerke, M. Bank and M. Steiger, ‘The Changing Role of Institutional Investors – A
German Perspective’ in K. Hopt and E. Wymeersch (eds.), Capital Markets and Company
Law (Oxford: Oxford University Press, 2003), p. 357; L. Zingales, The Future of Securities
Regulation (2009), ssrn abstractid=1319648; R. Deaves, C. Dine and W. Horton, How Are
Investment Decisions Made?, Research Study prepared for the Task Force to Modernize
Securities Legislation in Canada (2006) (‘Deaves Report’), p. 263 (reporting that 81 per cent
of Canadian retail investors hold mutual funds and 57 per cent hold stock). Institutional
investors, including CISs, have ‘enhanced their role as collectors of savings’: Ageing and
Pension System Reform: Implications for Financial Markets and Economic Policies (2005) (a
report prepared at the request of the Deputies of the G10 by an experts’ group chaired by
I. Visco, Banca d’Italia), p. 17. See also n. 80 below.
See further ch. 1.
product regulation and the retail markets
137
UCITS represent 80 per cent of the total EC CIS market.18 The UCITS has
established a global reputation,19 overtaking US mutual funds as the leading international fund investment.20 But the extent to which the UCITS
has become a template for CIS design and investor protection across the
Member States, the prevalence of retail investment in UCITS,21 and its
status as the preferred EC policy vehicle for supporting long-term savings,
means that the risks are significant if its regulatory design is weak.
2. The benefits of CIS product regulation
The regulation of investment products, and in particular of CISs, has long
been a component of retail market regulation, although it has recently
become less fashionable.22 Regulation, certainly in the Anglo-American
context, has traditionally been associated with the agency costs and
conflict-of-interest risks which follow when investor funds are entrusted
to the CIS.23 The potential of schemes for concentrating corporate control has also been associated with the development of the US regulatory
regime.24 The stakes have become higher, however, as the CIS industry
has burgeoned,25 as CIS policy becomes more central to retail market
18
19
20
21
22
23
24
25
Deutsche Bank, EU Asset Management, p. 1. Assets under management have been estimated at €7.6 trillion: PricewaterhouseCoopers, Investment Funds in the European Union:
Comparative Analysis of Use of Investment Powers, Investment Outcomes and Related Risk
Features in Both UCITS and Non-Harmonised Markets (2008) (‘2008 PwC Investment Powers
Report’), p. 13.
EFAMA, Annual Asset Management Report: Facts and Figures (2008), p. 9.
S. Johnson, ‘How UCITS Became a Runaway Success’, Financial Times, Fund Management
Supplement, 27 November 2006, p. 3.
EFAMA, Annual Asset Management Report 2008, p. 12. This reflects the US market where
first-time equity investors, ‘the ones on training wheels and especially deserving of regulatory attention’, are far more likely to invest in equity mutual funds than in individual
shares: H. Hu, ‘The New Portfolio Society, SEC Mutual Fund Disclosure and the Public
Corporation Model’ (2005) 60 Business Lawyer 1303, 1307.
FSA, The Turner Review: A Regulatory Response to the Global Banking Crisis (2009) (‘Turner
Review’), p. 87.
T. Frankel and L. Cunningham, ‘The Mysterious Ways of Mutual Funds: Market Timing’
(2006) 25 Annual Review of Banking and Financial Law 235; and A. Page and R. Ferguson,
Investor Protection (London: Weidenfeld and Nicolson, 1992), pp. 182–3.
M. Roe, ‘Political Elements in the Creation of a Mutual Fund Industry’ (1991) 139 University
of Pennsylvania Law Review 1469.
A. Khorana, H. Servaes and P. Tufano, Explaining the Size of the Mutual Fund Industry
Around the World (2004), ssrn abstractid=573503. In the US context, Mahoney, for example, has pointed to the dramatic increase in mutual fund investment between World War
II (US$1.2 billion) and 2002 (US$6 trillion) (P. Mahoney, ‘Manager–Investor Conflicts
138
product regulation
regulation26 and as CIS regulation has become more closely associated
with regulatory efforts to engineer stronger market engagement.
A recurring feature of the CIS debate is the argument that retail investors
should (and should be encouraged or even compelled to27 ) access the
markets through lower-cost,28 diversified, passive (index-tracking) CISs;29
this reflects engagement concerns but, in steering the investor towards
collective rather than direct investments, also has strong resonances with
the need to protect vulnerable trusting investors. Reflecting EC policy
enthusiasm for the UCITS product, the FSA, for example, has supported
collective investment as allowing retail investors to achieve higher returns
than those available from deposits.30
Related to this, product-based regulation of CISs can be regarded as,
in effect, ‘quasi-marketing’ these investment products as being somehow
‘appropriate’ for the retail markets. This has some intuitive appeal, particularly for vulnerable, but engaged and trusting, investors. CIS investment may address behavioural defects31 given the delegation of decisionmaking to an expert scheme manager and may mitigate the risks of poor
26
27
28
29
30
31
in Mutual Funds’ (2004) 18 Journal of Economic Perspectives 161), while Choi and Kahan
highlight the 20,000 per cent growth in assets under management between 1965 and 2004
(S. Choi and M. Kahan, ‘The Market Penalty for Mutual Fund Scandals’ (2007) 87 Boston
University Law Review 1021).
The US SEC’s regular monitoring of household mutual fund investment has been
characterized as a proxy for the relative effectiveness of its enforcement policy as
well as an indicator for market confidence: Frankel and Cunningham, ‘Mysterious Ways’,
255.
In an oft-cited proposal, Choi has suggested that retail investors be corralled into tracker
funds: S. Choi, ‘Regulating Investors Not Issuers: A Market-Based Proposal’ (2000) 88
California Law Review 279. Less radically, Zingales has suggested that the benefits of CIS
investment are such that broker/investor contracts for direct investment should contain a
risk warning as to the risks of direct investment: Zingales, The Future of Securities Regulation,
p. 28.
Although retail investors are poor at choosing low cost funds: sect. I.3.b below.
From an extensive and primarily US scholarship, see, for example, H. Jackson, ‘To What
Extent Should Individual Investors Rely on the Mechanisms of Market Efficiency: A Preliminary Investigation of Dispersion in Investor Returns’ (2003) 28 Journal of Corporation
Law 671; L. Ribstein, ‘Bubble Laws’ (2003) 40 Houston Law Review 77; D. Langevoort, ‘Rereading Cady Roberts: The Ideology and Practice of Insider Trading Regulation’ (1999) 99
Columbia Law Review 1319; and D. Langevoort, ‘Selling Hope, Selling Risk: Some Lessons
from Behavioral Economics about Stockbrokers and Sophisticated Investors’ (1996) 84
California Law Review 627.
FSA, Informing Consumers at the Point of Sale (Consultation Paper No. 170, 2003), p. 5
(while also acknowledging the risks).
G. La Blanc and J. Rachlinski, In Praise of Investor Irrationality (2005), ssrn
abstractid=700170, p. 22.
product regulation and the retail markets
139
decision-making in the direct trading context.32 Collective investment
trading costs, particularly for passive schemes, are lower than direct trading
costs.33 Schemes, and their supporting regulatory regimes, can, as is often
highlighted,34 support stronger diversification35 (although equity-marketindexed schemes can be less effective than balanced funds36 ), particularly
through international portfolios,37 and so manage general market risks.38
Intermediation through a CIS can mitigate the risks of counterparty failure; the ‘credit crunch’ saw exchange-traded funds (ETFs), and particularly bond schemes, increase in popularity.39 CIS investment and CIS
regulation can facilitate retail investor access to higher-risk/higher-return
schemes. The FSA’s development in 2008 of a fund-of-hedge-funds vehicle
(within the domestic non-UCITS regime), in order to support stronger
retail returns and better diversification, saw close attention to product
design,40 including the liquidity and valuation risks of scheme investment
in hedge funds assets.41 Liquidity and easy redemption, typically sought
by retail investors42 but also protections against general market risk, can
32
33
34
35
36
37
38
39
40
41
42
E.g. B. Barber, Y.-T. Lee, Y.-J. Liu and T. Odean, ‘Just How Much do Individual Investors Lose
by Trading?’ (2009) 22 Review of Financial Studies 609, finding that individual portfolios
suffered an annual performance penalty of 3.8 per cent. See further ch. 6.
A major survey into the cost of active investment in US equity has found that the costs of
active trading amounted to 0.82 per cent of the value of all NYSE, Amex and Nasdaq stocks
in 1980 and 0.75 per cent in 2006. Passive investment represented only 0.18 per cent of the
aggregate market capitalization in 1980 and 0.09 per cent in 2006: K. French, ‘Presidential
Address: The Cost of Active Investing’ (2008) 63 Journal of Finance 1537.
E.g. Mahoney, ‘Manager–Investor Conflicts’, 162–3; and J. Freeman and S. Brown, ‘Mutual
Fund Advisory Fees: The Costs of Conflicts of Interests’ (2001) 26 Journal of Corporation
Law 609, 614.
E.g. Jackson, ‘To What Extent’ (finding substantially higher rates of return for diversified
equity and bond mutual funds than for employee 401(k) pension funds).
Nonetheless, one financial crisis analysis has suggested that conservative index funds, traded
on an exchange, could become ‘building blocks for new retirement savings products’:
J. Authers, ‘Is It Back to the Fifties?’, Financial Times, 25 March 2009, p. 9.
W. Bailey, A. Kumar and D. Ng, Foreign Investments of US Individual Investors: Causes and
Consequences (2007), ssrn abstractid=633902.
EC investors increasingly seek diversification through CISs and exchange-traded funds:
Centre for Strategy and Evaluation Services, Study on the Impact of the Prospectus Regime
on EU Financial Markets (2008) (commissioned by the European Commission) (‘CSES
Report’), p. 21.
R. Sullivan, ‘Passive Fund Sector Ticks All the Boxes for Growth’, Financial Times, Fund
Management Supplement, 19 January 2009, p. 3.
FSA, Press Release, 22 February 2008 (FSA/PN/01(2008), noting that the new regime would
maintain consumer protection through product controls.
FSA, Funds of Alternative Investment Funds (Consultation Paper No. 07/6, 2006) and Funds
of Alternative Investment Funds (Consultation Paper No. 08/4, 2008).
J. Benjamin, Financial Law (Oxford: Oxford University Press, 2007), p. 189.
140
product regulation
also be supported as open-ended CISs allow redemption on request by
investors at a price related to the scheme’s net asset value (NAV). Overall,
CISs can facilitate mass market access to market investments43 and may
mitigate the market risks faced by retail investors.
Product regulation of this type also presents multiple design possibilities and, in its potential for commoditizing the retail product market, may represent a more appealing expression of consumerism in retail
market regulation than the empowerment model with its over-emphasis
on autonomy and choice. It allows the creative regulator to steer retail
investors towards preferred outcomes and, in particular, asset allocations
which hedge against market risk.44 By combining protection with support
of diversification and access to a range of investment strategies, CIS product design strategies can address a range of abilities and risk appetites.
They can also address product clarity, simplicity and costs. Product regulation can also mitigate regulatory risks. The risks of disclosure regulation
may be countered by asset allocation and governance requirements which
transfer much of the risk decision from the investor to the scheme.45
CIS product regulation can also ease some of the immense pressure on
distribution and advice regulation by simplifying schemes and by embedding advice elements within schemes (through product design and related
labelling techniques).46 This model has been attempted by the UK stakeholder/Sandler products regime, which also highlights how product regulation can be used ‘in action’ to support wider engagement with the
financial markets.
The 2002 Sandler Report into failures in the long-term savings market,47
which recommended that a suite of low-cost savings and investment
43
44
45
46
47
The US mutual fund industry has been described as ‘democratizing capitalism’: E. Roiter,
‘Delivering Fiduciary Services to Middle and Working Class Investors’ (2004) 23 Annual
Review of Banking and Financial Law 851, 852.
H. Hu, ‘Illiteracy and Intervention: Wholesale Derivatives, Retail Mutual Funds, and the
Matter of Asset Class’ (1996) 84 Georgetown Law Journal 2319, 2378.
H. Jackson, ‘Regulation in a Multi-sectored Financial Services Industry: An Exploration
Essay’ (1999) 77 Washington University Law Quarterly 319; and A. Palmiter, ‘The Mutual
Fund Board: A Failed Experiment in Regulatory Outsourcing’ (2006) 1 Brooklyn Journal of
Corporate, Financial, and Commercial Law 165.
ASIC’s deputy Chairman, for example, has suggested that regulation should consider
whether advice could be embedded within investment products given that the more functional and well designed a product is, the more limited the advice needs: J. Cooper, Deputy
Chairman ASIC, ‘Retail Investors – What More Can or Should We Do to Help Retail
Investors Build Long-Term Wealth?’, ASIC Summer School July 2008 Papers, p. 5.
The Sandler Report, Medium and Long-Term Retail Savings in the UK: A Review (2002)
(‘Sandler Report’).
product regulation and the retail markets
141
products be developed to overcome consumer reluctance to save, to reduce
product costs and complexity and to address the commission risks posed by
distribution, relied heavily on product design.48 The ‘stakeholder’ products regime which followed is based on a suite of simple, low-cost and
price-capped and risk-controlled49 products; the medium-term investment product, which includes a CIS,50 is subject to a principles-based
asset allocation regime which includes a 60 per cent limit on equity and
property-related investments.51 The regime has been regarded as a key element of the UK strategy for delivering investor protection and supporting
long-term savings,52 although its success has been questioned and it came
under review as part of the FSA’s Retail Distribution Review.53
Product regulation does not, however, have to be associated with product design. It can also be used as a means of attaching specific disclosure and
advice/distribution rules to sales of retail investment products which are
particularly risk-prone. The FSA’s ‘packaged products’ regime is designed
to ensure that particular distribution/advice, disclosure and conflict-ofinterest protections apply to the sale of nominated investment products
(including CISs) which are widely sold in the mass market but which are
often opaque and complex, are prone to investor misunderstanding and
confusion and the sale of which can be prone to commission risk.54 The
EC investment product regime, such as it is, has not taken this approach,
focusing on product design. But a change of approach may be in the
offing. The Commission’s radical April 2009 Communication on packaged products, in which it set out its response to the substitute products
48
49
50
51
52
53
54
‘[T]he heart of the solution lies in product regulation . . . [P]roduct regulation provides an
embedded means of protection that does not rely on advice and so minimizes the fixed
cost element of interacting with the consumer’: ibid., p. 23.
These features define the regime: HM Treasury, ‘Stakeholder’ Savings and Investment Products Regulation: Government Response (2004), p. 5.
The suite encompasses: a cash deposit account; a medium-term investment product (either
a CIS or a unit-linked life insurance product and including a ‘smoothed’ investment
product option); a long-term stakeholder pension; and an equity-based Child Trust Fund.
The smoothed product is designed to provide smoothed equity market exposure for entrylevel investors who want to avoid the highs and lows of equity investment (HM Treasury,
Consultation on ‘Stakeholder’ Savings and Investment Product Regulations (2004), pp. 9–11).
General asset allocation principles apply, including that assets be selected with regard to
the need to achieve a balance between growth and the risk of a loss of value and that
the manager have regard to diversification and the suitability of the investment strategy:
Financial Services and Markets Act 2000 (Stakeholder Products) Regulations 2004, reg. 7.
HM Treasury, Financial Capability: The Government’s Long-Term Approach (2007), p. 6.
FSA, Retail Distribution Review: Feedback Statement No. 08/6 (2008) (‘2008 RDR Feedback
Statement’), pp. 65–6. See sect. I.3.a below.
See further ch. 1.
142
product regulation
debate, suggests that it will attempt to reorient the harmonized disclosure
and advice/distribution regime away from its current segmented approach
and to construct a new disclosure and selling regime which will apply to
the sale of nominated packaged products.55
3. The risks of CIS product regulation
a) Design risks
CISs pose significant difficulties in terms of their ability to manage market
risk and support effective diversification (section III.2.a below), conflictof-interest risks (section II.2 below) and their ability to support investor
learning.56 But a host of other regulatory design challenges arise.
Commoditization of investor protection through product regulation
can represent a misallocation of regulatory resources. Characterizing CISs
as products might imply a light-touch approach which leaves monitoring to competitive market forces and product choice dynamics.57 But,
under the UCITS regime, commoditization has led to close regulatory
intervention in product design and to regulatory determinations as to the
appropriateness of particular investment strategies for the retail market.
By contrast, the massive US mutual fund industry is regulated through
an essentially corporate-law-based strategy, based (with respect to openended mutual funds) on fund oversight by its board and disclosure.58
Intervention UCITS-style carries a number of risks.
CIS product regulation requires the regulator to make choices concerning the structure and engineering of financial products59 which are
likely to be made more efficiently by the industry.60 The FSA has generally
55
56
57
58
59
60
Packaged Products Communication (sect. IV below).
Shiller has suggested that investor learning is limited given high costs and as investors tend
to switch and choose poorly performing funds: R. Shiller, Irrational Exuberance (Princeton
and Oxford: Princeton University Press, 2000), pp. 197–200.
D. Langevoort, Private Litigation to Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty (2006), ssrn
abstractid=885970, p. 21, suggesting that, once a scheme is regarded ‘as a product to
be marketed within liberal societal expectations as to fair advertising like another’, ‘the
transaction is . . . simply embedded in the morals of the marketplace’.
Palmiter, ‘Mutual Fund Board’.
Palmiter has observed that the ‘buck stops’ with the regulator in a product-based system
but with the board in the US regime: ibid., 207.
R. Karmel, ‘Mutual Funds, Pension Funds and Stock Market Volatility – What Regulation
by the Securities and Exchange Commission Is Appropriate?’ (2004–5) 80 Notre Dame Law
Review 909, 918.
product regulation and the retail markets
143
(aside from the UCITS regime) eschewed detailed product regulation.
It has been concerned as to the innovation risks which can flow from
product regulation and has assumed that the market is better placed to
judge whether products deliver value.61 Evidence from the UCITS III
industry, for example, points to some industry discipline in the design
of complex CISs (section III below). Close regulatory engagement in
the structure of schemes increases the more general risks of regulatory
intervention and may lead to regulation which responds to ill-defined or
poorly evidenced risks;62 the assumptions on which the disclosure and
conflict-of-interests regulation of the US open-ended mutual fund industry is based have, for example, been challenged.63 Regulatory intervention
is also likely to experience multiplier effects: more risky products will
demand more in terms of supporting risk management requirements,
as has been the case with the UCITS III product. The risks of regulatory over-reaction are high, given that CISs are associated with household
savings.64
Industry-facing moral hazard risks arise where regulation/public marketing provides a notional quality label for particular CISs.65 The risks are
also investor-facing. Labelling dynamics are strong in the retail investment
product market generally.66 Moral hazard difficulties can therefore arise
where ‘authorized’ or ‘retail market’ CISs are regarded as being somehow ‘safe’, particularly by vulnerable but trusting investors. Investors may
misunderstand the nature of government intervention, as has happened
with the UK’s equity Individual Savings Account (ISA) tax wrapper67
and was acknowledged by the FSA with respect to alternative investment
61
62
63
64
65
66
67
Turner Review, p. 106.
R. Romano, ‘A Comment on Information Overload, Cognitive Illusions, and Their Implications for Public Policy’ (1986) 59 Southern California Law Review 313, 320.
J. Coates and R. Hubbard, ‘Competition in the Mutual Fund Industry: Evidence and
Implications for Policy’ (2007) 33 Journal of Corporation Law 151; and Choi and Kahan,
‘Market Penalty’.
Roiter, ‘Delivering Fiduciary Services’, 865.
Gray, ‘Personal Finance’, 215–16; and J. Gray, ‘The Sandler Review of Medium and LongTerm Retail Savings in the UK: Dilemmas for Financial Regulation’ (2002) 10 Journal of
Financial Regulation and Compliance 385, 391.
Sandler Report, p. 18. Extensive US research has also found that investment decisions are
often made on the basis of popular brands: for example, A. Hortacsu and C. Syverson,
‘Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A
Case Study of S&P 500 Index Funds’ (2004) 119 Quarterly Journal of Economics 403.
It has been wrongly assumed to provide government-guaranteed returns: FSA, Towards
Understanding Consumers’ Needs (Consumer Research No. 35, 2005), p. 18.
144
product regulation
products.68 Where product regulation reforms facilitate riskier strategies but do not change the regulatory label, investor confusion risks can
arise. The UCITS label has become strongly associated with the retail
markets and high levels of investor protection, both in the EC69 and
internationally.70 Changes to its risk profile may not, as a result, be appreciated by the retail market, and mis-selling risks may arise.71
Product-based regulation is also complex. The UK experiment with
the ‘stakeholder’ products is not regarded as particularly successful, partly
because of the price caps which have limited industry enthusiasm. The
effectiveness of product design is also closely related to the related distribution and advice risks ‘in action’ which are difficult to manage (chapter 4);
the limited success of the stakeholder regime is also a function of perceived weaknesses in the related Basic Advice regime.72 Low levels of
investor demand, linked to the limited product range, the poor return
for firms and perceived high regulatory risk to firms from the limited
Basic Advice regime all led the FSA to consult on withdrawing the stakeholder products regime.73 The FSA’s attempts in its Retail Distribution
Review to link a more limited advice regime (Primary Advice) to the
sale of a limited range of products also foundered in the face of a hostile reception; the FSA itself showed limited enthusiasm for vetting and
pre-approving products for Primary Advice given the risks of product
regulation.74
Product regulation also carries the risk of obsolescence and of obstructing innovation; stronger investor returns and investors’ ability to manage
68
69
70
71
72
73
74
FSA, Wider-Range Retail Investment Products: Consumer Protection in a Rapidly Changing
World (Feedback Statement No. 06/3, 2006), pp. 5–6. The FSCP has also warned that, if a
wider range of non-UCITS alternative investment schemes were to be publicly marketed,
investors might unwisely derive security from their public marketing: Annual Report 2005–
2006, p. 16.
In France, the UCITS ‘brand name’ enjoys high recognition among savers (and distributors): Commission, Feedback Statement to the Green Paper on Enhancing the European
Framework for Investment Funds (2006), p. iii, while in the UK the FSCP has highlighted
wide consumer understanding of the UCITS product and highlighted the importance of
maintaining this ‘brand awareness’: FSCP, Response to Discussion Paper 05/3, p. 1.
2008 PwC Investment Powers Report, p. 8.
‘Trust takes years to build but can be lost very quickly if a scandal breaks . . . [T]he debate
about whether to extend the UCITS label to alternative investment funds is an important
one’: P. Skypala, ‘Careful Handling Needed to Safeguard UCITS’ Reputation’, Financial
Times, Fund Management Supplement, 14 April 2008, p. 6.
See further ch. 4.
2008 RDR Feedback Statement, pp. 65–6, although it has since decided to retain it
(chapter 4).
FSA, A Review of Retail Distribution (Discussion Paper 07/1, 2007) (‘2007 RDR’), p. 63.
product regulation and the retail markets
145
general market risk may be prejudiced. It may also be too blunt. Retail
investors, whether empowered or trusting, are not homogeneous;75 they
display different levels of sophistication, competence and risk appetite.76
Where regulation reflects a ‘one-size-fits-all’, mass market approach to
product regulation,77 the retail market may become dominated by generic
mass market products which do little to support investor learning, varying
degrees of risk appetite, and, ultimately, stronger returns.78 Conversely, the
pendulum can swing in the other direction, as is suggested by experience
with the UCITS III product (section III below).
The risks of regulatory arbitrage are also considerable when regulation
becomes segmented across different product lines, as is underlined by the
EC’s experience with substitute products (section IV below).
The resources expended on CIS regulation may also be misallocated
given that the extent to which product regulation can drive investor
behaviour is doubtful. Factors such as investor education and wealth,
over which the regulatory regime has limited traction, appear to drive
CIS industry growth.79 Although household participation seems, over
time, to shift from direct to indirect participation in the equity markets,80
the long-established US retail market points to the persistence of direct
investment in the markets, despite the relative benefits of fund-based
investments and the risks and costs of direct market trading.81 EC households have also been generally slow to invest in market instruments
through heavily regulated CISs, preferring often opaque and complex
insurance-related products and structured products which are less heavily
regulated.82
75
76
77
78
80
81
82
As evidenced, for example, by the Optem Report’s characterization of its data-set in terms of
savers and gamblers: Optem, Pre-contractual Information for Financial Services: Qualitative
Study in the 27 Member States (2008) (‘Optem Report’).
The FSA has, for example, acknowledged that only a ‘minority subset’ of investors are likely
to be equipped to engage with alternative investment products: FSA, Financial Risk Outlook
2005, p. 46.
P. Ring, ‘A Critical Analysis of Depolarization’ (2004) 12 Journal of Financial Regulation
and Compliance 248, 256, levelling this criticism at the stakeholder products regime.
Gray, ‘Personal Finance’, 216. 79 Khorana et al., Explaining the Size, pp. 3 and 15.
Individual holdings in the US equity market fell from 47.9 per cent in 1980 to 21.5 per
cent in 2007, but holdings in open-ended mutual funds increased from 4.6 per cent to
32.4 per cent over this period (French, ‘Cost of Active Investing’, 1539), leading to an
institutionalization of the market (e.g. J. O’Hare, Retail Investor Remedies under Rule 10b-5
(2007), ssrn abstractid=1019295, p. 4).
Langevoort, ‘Re-reading Cady Roberts’, 1328; and Ribstein, ‘Bubble Laws’, 97.
See further ch. 1 and sect. IV below.
146
product regulation
b) The investor choice assumption
Reflecting empowerment concerns, the UCITS product regime is preoccupied with investor choice.83 The Commission has warned generally
that product diversity is patchy and has targeted domestic rules which
prohibit cross-border product sales.84 The choice rhetoric has persisted
in the UCITS IV reforms which are designed to facilitate cross-border
UCITS activity through more efficient cross-border notification procedures, asset pooling and scheme mergers, a more effective UCITS business
chain (and in particular a passport for management companies) and more
efficient supervision.85 The UCITS IV reforms are designed to deliver a
more integrated UCITS market with ‘enlarged choice of better performing
funds’;86 the rationalization of schemes through the new mergers process,
for example, is designed to make investor choice easier and to reduce
confusion.87 The emphasis on increasing investor choice and, through
the earlier UCITS III regime, on facilitating industry innovation, suggests
that the UCITS regime is designed to support an ever-increasing supply of
schemes, already numbered at some 30,000.88 In all this, the retail investor
is assumed to benefit from greater choice and efficiencies; the projected
UCITS IV cost reductions are, for example, predicted to increase scheme
returns by 3 per cent.89
But investor prejudice can follow where an essentially facilitative and
choice-based strategy combines with poor investor choice and monitoring
and with limited industry incentives to produce investor-driven products.
CISs may fall within the regulatory parameters but be poorly distinguished,
complex and not responsive to investor needs. They may proliferate, confusing investors and increasing the mis-selling risks already posed by distribution and advice.
83
84
85
86
87
88
89
See also ch. 2 on the choice rhetoric and ch. 5 on comparability.
European Commission, A Single Market for 21st Century Europe (COM (2007) 725), Staff
Working Paper on Initiatives in the Area of Retail Financial Services, p. 3.
European Commission, Proposal for a Directive of the European Parliament and of the Council
on the co-ordination of laws, regulations and administrative provisions relating to undertakings
for collective investment in transferable securities (COM (2008) 458/3) (‘Commission UCITS
IV Proposal’).
Ibid., p. 4.
European Commission, UCITS IV Proposal, Impact Assessment (SEC (2008) 2236), p. 32.
At the end of 2005, some 44,489 investment funds were recorded in Europe, of which
almost 80 per cent (31,181) were UCITS schemes: 2008 PwC Investment Powers Report,
p. 17. In October 2007, 542 schemes were launched, although a sharp decrease occurred
as the ‘credit crunch’ intensified: B. Aboulian, ‘Product Development Falls off Agenda’,
Financial Times, Fund Management Supplement, 5 January 2009, p. 11.
Investment Funds White Paper, p. 3.
product regulation and the retail markets
147
The evidence of poor decision-making in CIS selection is considerable.
Investors tend to over-trade, buy high and sell low, over-react to market volatility and display herding behaviour.90 They over-rely on brands,
over-react to past performance disclosure and under-react to the costs of
schemes and the impact of expenses.91 They consistently choose more
costly, under-performing managed schemes rather than cheaper passive/index schemes.92 Choice of index scheme is also poor;93 investors
do not readily identify that costs are the determinative factor in choosing
between index schemes and do not search for the lowest cost schemes.94
The wealth of evidence on the massive US mutual fund market suggests
that those funds which receive most investment do not perform significantly better than other funds,95 that high levels of investor support predict low future returns96 and that, while investors tend to reallocate their
funds actively across different funds, they reduce their wealth in the long
term.97 There is, however, some evidence to the contrary which points
to investor discipline on fees98 and to a ‘smart money’ effect, whereby
investors’ fund choice predicts funds with a strong future performance,
although the evidence is not conclusive.99 Investors are acutely vulnerable to marketing, which is exploited by schemes,100 and to how providers
90
91
92
93
94
95
96
98
99
100
A. Frazzini and O. Lamont, ‘Dumb Money: Mutual Fund Flows and the Cross-Section of
Stock Returns’ (2008) 88 Journal of Financial Economics 299, 319.
Palmiter, ‘Mutual Fund Board’, 196–200. Ch. 5 considers cost disclosure weaknesses.
R. Otten and D. Bams, ‘European Mutual Fund Performance’ (2002) 8 European Financial
Management 75 (based on schemes in the UK, France, Germany, Italy and the Netherlands) (it found, however, some evidence of a correlation between management fees and
scheme performance). In the UK, the Sandler Report suggested that the CIS industry
under-performed the market by 2.5 per cent as a result of charges and unsuccessful active
management strategies which were not monitored by investors: Sandler Report, p. 2.
A weight of US evidence also points to this dynamic, for example, J. Cox and J. Payne,
‘Mutual Fund Expense Disclosures: A Behavioral Perspective’ (2005) 83 Washington University Law Quarterly 907.
E. Elton, M. Gruber and J. Busse, ‘Are Investors Rational? Choices Among Index Funds’
(2004) 59 Journal of Finance 261.
J. Choi, D. Laibson and B. Madrian, Why Does the Law of One Price Fail? An Experiment
on Index Mutual Funds (2008), ssrn abstractid=1125023.
L. Zheng, ‘Is Money Smart?: A Study of Mutual Fund Investors’ Fund Selection Ability’
(1999) 54 Journal of Finance 901.
97
Frazzini and Lamont, ‘Dumb Money’.
Ibid.
Coates and Hubbard, ‘Competition in the Mutual Fund Industry’, 183–4.
T. Sapp and A. Tiwari, ‘Does Stock Return Momentum Explain the “Smart Money” Effect?’
(2004) 59 Journal of Finance 2605; and K. Aneel and D. Stoli, ‘Which Money Is Smart?:
Mutual Fund Buys and Sells of Individual Investors’ (2008) 63 Journal of Finance 85.
P. Jain and J. Wu, ‘Truth in Mutual Fund Advertising: Evidence on Future Performance
and Fund Flows’ (2000) 55 Journal of Finance 937.
148
product regulation
label schemes.101 One troubling study has found that investors react to
cosmetic name changes which suggest a particular investment orientation
(for example, ‘value’ as opposed to ‘growth’) although the composition
of the fund portfolio has not changed.102 The EC evidence suggests that
‘shopping around’ is limited across the Community103 and that investors
have very limited ability to extend downward pressure on costs, despite
the benefits predicted from the UCITS IV reforms.104
Failure to choose on the basis of quality, and an inability to exert
pressure on costs, not only leads to poor individual resource allocation. It
removes a driver of competition and discipline from the CIS industry,105
as suggested by the evidence from Australia,106 and can lead to systemic
inefficiencies. Product differences can arise which are designed only to
differentiate the product from competitors’ products. Providers may be
driven by a concern to be ‘first to market’, rather than by a concern
to produce competitive products tailored to investor needs.107 Conversely,
and particularly in times of market stress, herding dynamics may be strong
as the industry, with limited investor discipline, may follow trends, as
occurred in the structured product sector;108 pressure is also currently on
providers to produce high-margin products.109 Poor choice is exacerbated
101
102
103
104
105
106
107
108
109
Investor confusion risks concerning capital protection and guarantees have, for example,
been raised with respect to the use of the ‘cash-plus’ label by CISs: K. Nickerson and
S. Grene, ‘IMA Concern over “Cash-Plus” Label’, Financial Times, Fund Management
Supplement, 12 January 2009, p. 2.
M. Cooper, H. Gulen and R. Raghavendra, ‘Changing Names with Style: Mutual Fund
Name Changes and Their Effects on Fund Flows’ (2005) 60 Journal of Finance 2825.
Oxera, Current Trends in Asset Management: Prepared for the European Commission: Executive Summary (2006), p. v; and see further ch. 2.
One study has warned that, in part because of product complexity and poor financial
capability, cost savings would be only slowly passed on to consumers: CRA International,
Potential Cost Savings in a Fully Integrated European Investment Fund Market (2006), p. 14.
Sandler Report, p. 46.
The lack of downward pressure on the Australian fund market, notwithstanding its size
(the world’s largest per capita), has been linked to investor inability to assess complex
product disclosures: R. Bollen, ‘A Case Study of Bounded Rationality in the Market for
Superannuation Products’ (2007) 4 Macquarie Journal of Business Law 49.
L. Costanzo and J. Ashton, ‘Product Innovation and Consumer Choice in the UK Financial
Services Industry’ (2006) 14 Journal of Financial Regulation and Compliance 285 (in the
context of deposit products).
E. Avgouleas, What Future for Disclosure as a Regulatory Technique? Lessons from the Global
Financial Crisis and Beyond (2009), ssrn abstractid=1369004, p. 13. US mutual funds were
among the purchasers of collateralized debt obligations (CDOs) and residential mortgagebacked securities (RMBSs), leading to significant litigation in the US: A. Ferrell, J. Bethel
and G. Hu, Legal and Economic Issues in Litigation after the 2007–2008 Credit Crisis (2008),
ssrn abstractid=1096582.
FSA, Financial Risk Outlook 2009, p. 65.
product regulation and the retail markets
149
by the related potential for the CIS industry to be segmented,110 with
inferior products marketed to less discerning retail investors and insulated
from market monitoring by more sophisticated investors. In the absence of
investor monitoring, product provider discipline becomes a function of the
problematic distribution process. Increasing product complexity has been
associated in the UK open distribution context (which is slowly becoming
more widespread across the EC) with incentives for product providers to
create complex products which can justify higher commissions111 given
the competition for ‘shelf space’. Already severe commission risks can be
deepened.
The structure of the UCITS industry suggests limited investor discipline
and poor choice. The Commission has charged the industry with delivering
sound CISs which deliver the highest possible returns consistent with
investors’ financial capacity and risk appetite112 and the UCITS III regime
has supported a vast range of UCITS products. But concerns remain
that investors are not provided with appropriate products.113 Investor
confusion is considerable as UCITS III products proliferate.114 Products
have become very difficult to compare. CISs still lag some way behind bank
deposits and often complex and risky unit-linked insurance products in
investor popularity;115 while German households have increased their CIS
holdings, reductions have occurred in the Netherlands and Italy.116 A
wide range of factors drive investment decisions; but it is probably not
unreasonable to suggest that the relative popularity of generally lowerreturn bank accounts, even prior to the ‘credit crunch’, points to the failure
of the CIS/UCITS industry to deliver appropriate and clear products, as
well as to the deterrent effects of investor confusion. The market turbulence
related to the ‘credit crunch’, which led to serious investor losses,117 has
also seen some criticism of the CIS industry for the failure of high-cost
110
111
113
114
115
116
117
Mahoney, ‘Manager–Investor Conflicts’.
Sandler Report, pp. 17 and 19. 112 Investment Funds Green Paper, pp. 2–3.
One report has suggested that many UCITS are unfit for purpose with unclear risk/return
characteristics, excessive volatility and poor liquidity: Skypala, ‘Squabbling’. The Council’s Financial Services Committee has called for ‘simple and transparent products and
products that automatically take into account the changing investment needs of an ageing
population’: Subgroup on the Implications of Ageing on Financial Markets, Interim Report
to the FSC (FSC4180/06, 2006) (‘FSC Report’), p. 21.
Expert Group on Investment Fund Market Efficiency, Report (2006), p. 10.
See further ch. 1.
BME Consulting, The EU Market for Consumer Long-Term Retail Savings Vehicles: Comparative Analysis of Products, Market Structure, Costs, Distribution Systems, and Consumer
Savings Patterns (2007) (‘BME Report’), p. 54.
See further ch. 2.
150
product regulation
and complex schemes, including absolute-return schemes, to perform118
(CESR, in particular, has questioned the relationship between fees and
performance119 ).
Investor confusion and product complexity risks are increasingly a policy concern in the highly developed UK product market in which more
than 2,000 retail market CISs (including UCITS) are sold,120 not least as
these risks are aggravated by commission-based sales. The FSA has repeatedly highlighted the risks in its annual Financial Risk Outlooks, which
suggest increasing FSA scepticism as to the benefits of choice,121 while
its major 2006 review of financial capability highlighted poor product
choice in general, limited awareness of risk and little shopping around
for products.122 In its recent review of alternative investment policy, the
FSA similarly warned that product innovation was only beneficial where
it resulted in useful products123 and that a wider product range could
simply confuse investors.124 Notably, some limited restrictions on choice
have been incorporated into the advice regime for stakeholder products.
The regime restricts investor choice by limiting Basic Advisers to presenting only one CIS or unit-linked insurance product at the point of
sale, partly in order to prevent advisers from engaging in judgments as to
the relative merits of different products.125 But the risks posed by excessive choice are also reflected in this model, which is expressly designed
to support the most inexperienced investors. Although the UK market
is strongly characterized by investment product sales, product proliferation, complexity and confusion risks are also a concern in other Member
States.126 The UCITS regime has yet, however, to engage with the very difficult problem ‘in action’ of how to incentivize providers to produce clear
products which meet investor needs; the developing policy on alternative
118
119
121
122
123
124
125
126
CESR, Annual Report 2007, p. 19. Absolute return funds were under-performing before
the major market shocks in autumn 2008.
Ibid. 120 HM Treasury, Financial Capability (2007), p. 10.
The FSA’s 2007 Financial Risk Outlook, for example, argued that, while increased product
choice was generally positive, some consumers did not understand the risks: p. 9.
FSA, Financial Capability in the UK: Establishing a Baseline (2006), p. 17.
FSA, Consultation Paper No. 07/6, p. 7.
FSA, Wider Range Retail Investment Products: Consumer Protection in a Rapidly Changing
World (Discussion Paper No. 05/3, 2005), p. 7.
COBS 9.6.3.
E.g. J. Delmas-Marsalet, Report on the Marketing of Financial Products for the French
Government (2005) (‘Delmas Report’), p, 29. The German BaFIN has also pointed to the
risks of confusion (Annual Report 2006, p. 27), while the Dutch AFM has pointed to the
importance of comparability across different products (AFM, Annual Report 2006, p. 52).
product regulation and the retail markets
151
investment products (section III below) suggests, however, that some
nuance may be emerging.
4. An integrated model
So where do product design risks leave CIS product regulation and the
UCITS model? One response might be that more and not less product
regulation is required given that market forces do not seem to be delivering appropriate products.127 But the risks of greater EC intervention are
considerable, not least given centralization risks, and retail market commoditization is not a complete strategy. Multiple and unwieldy regulatory
levers must instead be manipulated to achieve outcomes ‘in action’ and
to incentivize the industry to deliver products which, while within the
regulatory product parameters, respond to investor needs. A careful interplay is required between relatively untested distribution/advice suitability,
conflict-of-interest and inducement rules under MiFID (chapter 4) and
the UCITS disclosure regime (chapter 5). Considerably heavy lifting is also
required of financial literacy if empowered and trusting retail investors are
to place themselves correctly on the UCITS risk spectrum.
The need for an integrated strategy has been highlighted by two
important national reviews: the UK Retail Distribution Review; and the
2005 French Delmas Report. The Retail Distribution Review identified
a series of risks leading to inefficiencies and mis-selling in the product market generally (including CISs), including product complexity,
poor investor understanding and inability to exert discipline on product design and a consequent reliance on commission-based independent
advisers.128 The Delmas Report highlighted information and disclosure
weaknesses, the increasing complexity of often poorly targeted products and the risks posed by the distribution of proprietary products.129
The UK’s Retail Distribution Review efforts to address the risks of the
advice industry, discussed in chapter 4, are supported by attempts to
improve product design, marketing and distribution under the Treating Customers Fairly (TCF) initiative (section III below). The Delmas
Report also called for a series of intersecting reforms addressing disclosure
127
128
The Turner Review suggests greater FSA openness, in the wake of the financial crisis and
the weaknesses it exposed in market discipline, to retail market product regulation, albeit
in the context of mortgage products: Turner Review, pp. 106–8.
2007 RDR, pp. 3–4. 129 Delmas Report, pp. 10–11.
152
product regulation
design, marketing and distribution risks, and the design of appropriate
products.130
The lesson from the UCITS regime for retail market design seems to be
that prescriptive asset allocation and design rules are unlikely to provide
industry incentives to respond to investor needs and that excessive product
choice may be a pernicious risk. The product orientation of the detailed
EC regulatory regime may, as a result, be both flawed and liable to mask
underlying risks. The following sections, after an overview of the UCITS
regime, consider the troublesome design lever and whether it can be finetuned to achieve positive retail market outcomes.
II. The UCITS investor protection regime and product regulation
1. Inbuilt diversification and liquidity
In the UCITS regime, product design has three dimensions: structure and
investment policy; authorization and supervision of the scheme manager
and depositary; and a public marketing restriction – only UCITS schemes
authorized under the Directive can be publicly marketed (Article 4).131
Specific requirements support diversification and liquidity. The Directive applies to undertakings for collective investment in transferable securities, the sole object of which is the collective investment of public capital
in transferable securities and/or in other ‘liquid financial assets’ and which
operate on risk-spreading principles (Article 1). This core diversification
requirement is supported by a liquidity rule; UCITS units must, at the
unit-holder’s request, be capable of repurchase or redemption, directly
or indirectly, out of UCITS assets (Article 37(1)). This requirement also
underpins the extensive asset allocation and diversification regime (section
III) and is at the heart of UCITS product design. Redemption on demand
protects retail investors against liquidity risks; it allowed retail investors
to move in large numbers to deposits over the worst of the 2008 market
turbulence.132 But it also provides investors with a powerful mechanism
for monitoring schemes or, at least, exiting under-performing schemes,
with ease,133 although retail investors typically do not closely monitor
performance.134 The UCITS Directive leaves, however, the management
130
131
132
133
Ibid., pp. 20–44.
Authorization also supports the cross-border passport (Arts. 4 and 44).
Although large losses were also crystallized. See further ch. 2.
Coates and Hubbard, ‘Competition in the Mutual Fund Industry’. 134 See further ch. 2.
the ucits regime and product regulation
153
of related valuation and redemption risks135 to the scheme and/or the
Member States.136 Redemption is also supported by the requirement that,
while a UCITS may be constituted according to the law of contract, trust
law or under statute (in corporate form), it must be open-ended (Article
1(3)) and so capable of supporting redemption on demand.
Closed-end schemes (or schemes which can apply redemption restrictions) are accordingly excluded. These include closed-end corporate structures (including UK ‘investment trusts’) in which the investor holds a
share and is exposed to the usual equity and trading risk, as well as the
risk that these structures typically trade at a discount to net asset value
(NAV).137 The EC regime for these schemes is limited to the Prospectus Directive’s disclosure regime (chapter 5) and, where the securities are
admitted to trading, the skeletal admission to trading regime (section IV).
Although the importance of liquidity protection became clear over the
‘credit crunch’,138 the Directive’s restriction to open-ended schemes simply
reflected the popularity of open-ended schemes at the time, and concern
as to their susceptibility to failure unless careful portfolio management
addressed redemption risks, rather than a considered consideration of the
relative risks of different structures.139 The distinction exposes, however,
the risks of segmented product regulation. Closed-end products have, as
discussed in section IV below, become a target for regulatory arbitrage.
2. Inbuilt governance: the depositary and the management company
Authorization and operational/conduct-of-business rules, embedded
within the UCITS product, apply to the different entities which constitute
135
136
137
138
139
In the US, a range of factors, including increased reliance on derivatives and the globalization of trading, sharpened the NAV measurement risks to investors and led to the market
timing scandal (n. 160 below): Frankel and Cunningham, ‘Mysterious Ways’, 240–9.
Art. 38.
A. Shleifer, Inefficient Markets: An Introduction to Behavioural Finance (Oxford: Oxford
University Press, 2000), pp. 53–88.
The credit crunch saw non-UCITS funds apply for exemptions to redemption requirements as liquidity dried up, but retail UCITS funds remained subject to on-demand
redemption: B. Aboulian, ‘Liquidity Tightening Now on the Agenda’, Financial Times,
Fund Management Supplement, 12 January 2009, p. 11. UK investment trusts, for example, came under severe pressure over the credit crunch, experiencing very steep discounts
to NAV and severe liquidity difficulties: S. Johnson, ‘Rescue Plan for Investment Trusts’,
Financial Times, Fund Management Supplement, 9 February 2009, p. 1.
The Directive simply noted that extending the regime to other funds ‘poses a variety of
problems’ which were to be dealt with through later co-ordination: recital 16.
154
product regulation
the UCITS, namely, for UCITS in the form of a unit trust, the management company which manages the assets and markets the trust and the
depositary which holds the assets and, for UCITS in corporate form, the
(investment) company, which may also be the management company or
a separate management company may be designated, and the depositary.
Competent authorities must approve the unit trust management company,
scheme rules and the choice of depositary and the investment company’s
instruments of incorporation and the choice of depositary (Article 4(2)).
The depositary, to which scheme assets must be ‘entrusted for
safekeeping’140 and which is subject to high-level rules,141 is key to the
Directive’s embedded investor protection and conflict-of-interest management regime. It acts as the custodian of scheme assets and is responsible for essential technical procedures relating to asset administration142
and for ensuring they are carried out in accordance with the law and the
UCITS’ rules. The depositary is not subject to extensive authorization
requirements, given that depositaries will often be regulated credit institutions. The directors must, however, be of sufficiently good repute and
sufficiently experienced in relation to the type of UCITS to be managed,143
and the depositary must take the form of an institution subject to public control, be situated so as to ease supervision144 and furnish sufficient
financial and professional guarantees that it can effectively pursue its
business and meet its commitments.145 Independence is supported by the
requirement that a single company may not act as both a management
company and a depositary; the depositary (and the management company) are also required to act independently and solely in the interests of
unit-holders.146 The centrality of the depositary to investor protection and
to the strength of the UCITS brand became clear as the Madoff scandal
unfolded amidst concerns that Luxembourg and Ireland, the two centres
with schemes exposed to the Madoff fraud, had not imposed sufficiently
140
141
142
143
144
145
146
Arts. 7(1) (unit trusts) and 14(1) (investment companies).
Arts. 7 (unit trusts) and 14 (investment companies).
Arts. 7(3) (unit trusts) and 14(3) (investment companies – valuation requirements do not
apply). Investment company depositaries are subject to broadly the same regime as unit
trust depositaries, subject to some slight differences, including lighter duties, given the
notional role of shareholder discipline (Art. 14(3)).
Art. 4(3).
Under Art. 8(1) (Art. 15 for investment companies), the unit trust depositary must either
have its registered office in the same Member State as that of the management company
or be established in that Member State where its registered office is elsewhere.
Arts. 8 (unit trusts) and 15 (investment companies).
Arts. 10 (unit trusts) and 17 (investment companies).
the ucits regime and product regulation
155
rigorous controls on UCITS depositaries who had outsourced custodian
functions147 to Madoff affiliates and who had not confirmed the existence of the underlying assets.148 Concern as to potential damage to the
UCITS brand led to a Commission review of Member State implementation of the depositary requirements.149 While only a very small number
of schemes was affected,150 and the UCITS brand does not appear to be
significantly damaged,151 the outsourcing of custodianship functions, permitted under the Directive, represents a significant risk in times of acute
market volatility152 and was highlighted by the 2009 de Larosi`ere Report.153
Authorization requirements also apply to the management company or
investment company (Article 4(3)) which manages the assets.154 So too do
operational requirements,155 but the conduct-of-business and conflict-ofinterest regime156 is more notable for its exclusions than for its coverage.
147
148
149
150
151
152
153
154
155
156
Depositaries’ liability under Arts. 9 and 16 (which impose liability towards unit-holders
for any loss suffered by them as a result of ‘unjustifiable failure to perform its obligations’
or ‘improper performance’) is not affected where the depositary has entrusted assets to a
third party: Arts. 7(2) and 14(2).
E.g. S. Grene, ‘Luxembourg Called on to “Brush up” Governance’, Financial Times, Fund
Management Supplement, 26 January 2009, p. 3, highlighting the risks to the UCITS
brand as over 30 per cent of UCITS funds are domiciled in Luxembourg. Stricter French
rules and French investor losses led to France demanding a Commission review of pan-EC
implementation of the depositary requirements, amidst confusion as to the scope of the
Directive’s asset protection rules.
European Commission, Press Release IP/09/126, 29 January 2009.
Four UCITS funds entrusted assets to Madoff affiliates: Commission Press Release
IP/09/126, 29 January 2009.
Hedge fund investors appear to want to use UCITS III structures, and benefit from stronger
custody arrangements, in the wake of the Madoff fraud: S. Johnson, ‘Hedge Funds March
Towards UCITS’, Financial Times, Fund Management Supplement, 23 February 2009,
p. 1.
FSA, Financial Risk Outlook 2009, p. 66.
The High-Level Group on Financial Supervision in the EU, Report (2009) (‘de Larosi`ere
Report’), p. 26. It called for tighter harmonized regulation of delegation and warned that
the separation between asset management and custody, required by the UCITS regime,
should be respected whatever delegation model was used.
Arts. 5, 5a and 5b govern the authorization process and cover capital requirements,
scope of activities, management suitability, prudential requirements concerning close links
with other entities and qualifying shareholders. A similar regime applies to investment
companies (Arts. 12–13a).
Where a management company engages in MiFID activities, notably investment advice
and discretionary portfolio management (as permitted by Art. 5(3)), the MiFID regime
applies in respect of those activities (Art. 5(4)).
Prudential requirements concerning ongoing capital requirements, qualifying shareholdings and operational prudential rules (particularly with respect to administrative procedures and transaction reconstruction) also apply (Arts. 5(d)–(f)) (Arts. 13b and 13c for
investment companies).
156
product regulation
The conflict-of-interest regime, central to managing investor protection
risks, is considerably less sophisticated than that which governs discretionary asset management under MiFID and does not reflect international best practice.157 The rules include the general requirement that a
management company be structured and organized in such a way as to
minimize the risk of UCITS’ (or clients’) interests being prejudiced by
conflicts (Article 5f(1)).158 Conduct-wise, Article 5(h), a now-outdated
provision, simply requires Member States to draw up conduct rules which
management companies authorized in that Member State are to observe
at all times and which must implement the skeletal Article 5h principles.
Conflict-of-interest management is central to retail investor protection
in the CIS context given the agency costs and risks which arise between
ill-informed and passive investors and CIS managers.159 While ease of
redemption means that investors can exit, in practice they are unlikely to
monitor schemes closely and will rarely have sufficient influence to hold
the scheme to account. Conflicts of interests and incentive misalignment
can result in the extraction of benefits through excessive costs, which
have proved very difficult to deal with through disclosure (chapter 5), in
abusive trading practices, as evidenced by the US market timing scandal,160
incompetence in CIS management and fraudulent diversion of assets from
the CIS. These risks are exacerbated as the disciplines imposed by marketpricing dynamics are weakened as CIS pricing (with respect to non-traded
CISs) is closely related to NAV.161
But the UCITS regime does not address in any detail conflict-of-interest
and governance risks. The particular conflicts of interests generated by the
UCITS industry and, in particular, by the management, depositary and
sales/distribution function all being carried out within a single, typically
157
158
159
160
161
The IOSCO Objectives and Principles of Securities Regulation (IOSCO, 2008), for example,
call for rules governing best execution, timely allocation of transactions, commissions and
fees, related-party transactions, underwriting arrangements and delegation.
It is supported by the requirement that investment management mandates may not be
delegated to the depositary or any other undertaking whose interests may conflict with
those of the management company or unit-holders (Art. 5g(1)) and the requirement that
the management company must try to avoid conflicts of interest and, when they cannot
be avoided, ensure that the UCITS it manages are fairly treated (Art. 5h). The same regime
applies to investment companies (Art. 13b).
Langevoort, Private Litigation; and Mahoney, ‘Manager–Investor Conflicts’.
The US market timing scandal which broke in 2003 saw the uncovering of widespread
abuses with particular investors (mainly hedge funds) being given preferential pricing
and wider opportunities to trade, leading to prejudice to other investors: J. McCallum,
‘Mutual Fund Market Timing: A Tale of Systemic Abuse and Executive Malfeasance’ (2004)
12 Journal of Financial Regulation and Compliance 170.
Langevoort, Private Litigation.
the ucits iii product and design risks
157
banking, group have also not been addressed.162 As outlined in chapter
4, mis-selling risks remain significant where investors are advised on/sold
proprietary CISs. Collective portfolio management also raises the risk
that ‘soft commissions’ and ‘bundling’ arrangements generate conflicts of
interests and increase costs. Commission structures of this nature may bias
portfolio managers towards particular brokers and threaten best execution,
risk that scheme assets are ‘churned’ to generate commissions and lead to
less discrimination in the use of research where research is provided under
commission arrangements.163 While the generic UCITS conflicts regime
provides some protection (depending on how it is enforced), Community
retail market policy has not (as discussed in chapter 4) directly tackled
the difficult market structure questions raised by product distribution,
commission structures, and bundling and softing arrangements.
Member States have, of course, imposed national rules on CIS governance and trading practices.164 But, while market timing abuses, in
particular, have not been a feature of the European industry,165 the policy
priority afforded to asset allocation in the UCITS regime, combined with
market integration priorities, may have driven an unwarranted EC focus
on extending the boundaries of the UCITS product. On the other hand,
it might also be argued that the absence of major concern with respect
to conflicts of interests and excessive fees points to this issue being more
effectively dealt with at Member State level and to the UCITS regime
appropriately managing centralization risks and identifying those issues
which require harmonized intervention.
III. The UCITS III product and design risks
1. The UCITS III regime
Radical reforms to the original 1985 UCITS asset allocation regime under
the UCITS III regime have allowed UCITS to extend their investment
162
163
164
165
E. Wymeersch, Conflicts of Interest – Especially in Asset Management (Financial Law Institute Gent, Working Paper No. 2006-14), 2006), available via www.law.ugent.be/fli/WP/.
E. Pinciss, ‘Sunlight is Still the Best Disinfectant: Why the Federal Securities Law Should
Prohibit Soft Dollar Arrangements in the Mutual Fund Industry’ (2004) 23 Annual Review
of Banking and Financial Law 864.
The Dutch regulator, the AFM, for example, carried out an extensive examination into
the fund market, governance and trading practices and introduced a series of reforms: for
example, AFM, Monitoring Collective Investment Schemes (2004).
CESR Chairman Docters van Leeuwen, Speech on ‘Management of Conflicts of Interest –
Is There a European Way?’, 24 September 2004 (CESR/04-483, 2004), reporting that CESR
members had not found major evidence of mispractices concerning late trading or market
timing.
158
product regulation
horizons from listed shares and bonds to a range of ‘liquid financial
instruments’ (Articles 1(2) and 19), including bank deposits,166 moneymarket instruments (listed (in the Community and elsewhere) and OTC
(where liquidity requirements are met)),167 units of non-UCITS CISs
(where they are ‘equivalent’ to UCITS),168 and financial derivatives (listed
and OTC).169 Investment strategies associated with cost reduction and
diversification, such as index-tracking170 and fund-of-funds structure,171
are also supported.
Specific diversification requirements apply, including that a UCITS
may invest no more than 5 per cent of its assets in the transferable securities or money-market instruments of a single issuer (Member States
may raise this limit in certain circumstances);172 similar limits apply to
deposits and financial derivatives.173 UCITS are also prohibited from
investing more than 10 per cent of assets in transferable securities and
money-market instruments other than those covered by the Directive.174
The regime is also supported by maximum derivatives exposure limits,
controls on leverage and risk management requirements (designed to
ensure that assets, and particularly OTC derivatives, are sufficiently liquid
and accurately monitored, measured and managed), which are amplified
by the Commission’s 2004 Recommendation.175 The leverage controls,
in particular, provide some protection against general market risk by
limiting the product’s exposure.176 Specific capital requirements do not
166
168
169
171
172
173
174
175
176
Art. 19(f). 167 Art. 19(1)(a)–(c) and (h).
Art. 19(1)(e). Some protection is provided against opaque cascades of CIS investments by
the requirement that a UCITS may not invest in units of another UCITS or CIS which
itself invests more than 10 per cent of its assets in units of other UCITS and/or CISs.
Art. 19(1)(g). 170 Art. 22a.
Art. 24(1); ‘feeder’ funds which invest all their assets exclusively in the units of one UCITS
(the ‘master’ fund) are not currently permitted, although they are provided for under the
UCITS IV reforms.
Art. 22(1).
A UCITS may not invest more than 20 per cent of its assets in deposits made with the same
body, while the risk exposure to a UCITS counterparty in an OTC derivative transaction
may not exceed 10 per cent of assets when the counterparty is a credit institution or, in all
other cases, 5 per cent of assets (Art. 22(1)).
Art. 19(2)(a).
European Commission Recommendation 2004/383/EC of 27 April 2004 on the use of
financial derivative instruments for undertakings for collective investment in transferable
securities, OJ 2004 No. L144/33.
Art. 36 prevents investment companies and management companies and depositaries
acting on behalf of a UCITS from borrowing, while global exposure to financial derivative
instruments is limited to 100 per cent of the UCITS’ net asset value and the UCITS’ overall
the ucits iii product and design risks
159
apply.177 Short-selling, a strategy strongly associated with hedge funds but
which has become associated with the ‘credit crunch’ convulsions, is permitted, but is limited by the restrictions placed on the use of derivatives
as well as by the prohibition on uncovered short sales (Article 42).178
Although the UCITS remains strongly characterized as a retail market
product institutionally,179 the UCITS III reforms have seen the UCITS
change from a conservative investment vehicle to something of a bellwether
for innovation. This is particularly the case at levels 2 and 3180 of the
UCITS regime which have amplified ‘liquid financial instruments’ and
‘transferable securities’ to include a range of riskier and less liquid assets
including the structured debt products which caused so much difficulties
in the banking market,181 credit derivatives, closed-end funds, financial
indices and transferable securities and money-market instruments which
embed derivatives. Structured financial instruments, for example, may be
inappropriate for a retail investment vehicle,182 but CESR’s approach was
broadly facilitative. In an eye-catching CESR decision, hedge fund indices
177
178
179
180
181
182
risk exposure is limited to 200 per cent of net asset value (Art. 21(3) and Recommendation,
para. 2.1).
The European Parliament, however, has called for all financial institutions, including
UCITS, to comply with risk-based capital requirements: European Parliament, Resolution
with Recommendations to the Commission on Hedge Funds and Private Equity (2008)
(P6 TA(2008)0425, 2008), Annex, recital 1.
CESR’s level 3 guidance on UCITS-eligible assets was amended in September 2008 as
prohibitions were placed on short-selling across Europe to clarify that physical shortselling, whether or not backed by stock borrowing, is not permitted under the UCITS
Directive (CESR/07-044b, 2007, p. 12). Recommendation 7 of the 2004 Recommendation
addresses covered sales.
Commissioner McCreevy, for example, has warned that ‘we must be careful not to
undermine the pretensions of UCITS to be a retail investor product’: Commissioner
McCreevy, Speech on ‘The EU Framework for Investment Funds: A Facilitator – Not a
Strait Jacket’, Commission Hearing on Investment Funds, 13 October 2005, available via
http://europa.eu/rapid/searchAction.do.
European Commission Directive 2007/16/EC of 19 March 2007 implementing Directive
85/611/EC as regards certain definitions, OJ 2007 No. L79/11 (‘Level 2 Eligible Assets
Directive’) (CESR’s Level 2 Advice is at CESR/06-005 (‘CESR Level 2 Advice’) and the
earlier consultation papers are at CESR/05-064b and CESR/05-490b) and CESR, 2007
Level 3 Guidance on Eligible Assets (CESR/07-044, 2007).
Such as collateralized debt obligations and structured investment vehicles. CESR adopted
the general principle that investments in the form of transferable securities (such as
structured investments) should be allowed (CESR Level 2 Advice), subject to, for example,
valuation, liquidity, disclosure and risk management requirements (Level 2 Eligible Assets
Directive, Art. 2).
‘[These products] could potentially pose a threat to the liquidity of the UCITS making it
difficult for investors to redeem their units at a price that fairly reflects the value of the
investment or . . . at all’: CESR/05-064b, 2005, p. 9.
160
product regulation
are also eligible, albeit following difficult CESR discussions.183 CESR’s
willingness to embrace a robust approach towards the retail markets has
had multiplier effects; the inclusion of hedge fund indices has since been
used as an argument for either bringing funds-of-hedge-funds within the
UCITS regime or for establishing a discrete EC product regime for hedgefund-like investments. It has also supported Member State moves to widen
retail access to hedge fund investments through funds-of-hedge-funds.184
Overall, the UCITS III regime reflects an enabling characterization
of the investor as empowered and risk-tolerant185 and supports investor
choice of higher risk levels for higher reward. There was, however, little
discussion of the link between the UCITS III regime and the nature of
the EC retail market in CESR’s discussions or in European Securities
Committee (ESC) minutes. It is doubtful that the new regime reflects a
considered stance on the level of risk which should be contained within
the UCITS III product.
The risks may be mitigated in that there appears to be some degree of
industry discipline with respect to the risk profile of UCITS III schemes.
Although UCITS III schemes are burgeoning and, in particular, adopting
derivative-based strategies,186 the 2008 PricewaterhouseCoopers study of
the UCITS III sector187 produced some heartening results. It found that,
while reliance on derivatives had increased,188 UCITS III investment powers were being used effectively and market risk levels were not significantly
higher as compared to other CISs.189 Derivatives were generally relied
183
184
185
186
187
188
189
CESR raised a number of concerns with respect to hedge fund indices, including survivor
bias (under-performing hedge funds are not included in indices as they usually close
down) and selection bias (CESR Level 2 Advice, p. 53), and originally excluded them from
its level 2 Commission advice (p. 57). It reopened the issue through consultations in
2006 (CESR/06-530, 2006) and 2007 (CESR/07-045, 2007) and agreed to limited UCITS
investment in particular hedge fund indices, subject to a series of eligibility conditions
(CESR, Level 3 Guidelines on Classification of Hedge Fund Indices as Financial Indices
(CESR/07-434, 2007)).
The FSA’s widening of retail investor access to funds-of-hedge-funds was based in part on
the exposure being gained by investors through UCITS III structures: Consultation Paper
No. 07/6, p. 7.
The Commission suggested that, while consumers would be faced with ‘some very complex
retail products’ and exposed to risks beyond market risk and including operational and
counterparty risks, ‘this is not a problem of itself’: European Commission, Simplified
Prospectus Workshops 15 May 2006 and 11 July 2006: Issues Paper (2006), p. 14.
S. Johnson, ‘New Products Make Use of UCITS Power’, Financial Times, Fund Management
Supplement, 12 March 2007, p. 3.
2008 PwC Investment Powers Report.
Growth in the rate of derivative use has been estimated at 10 per cent per annum.
2008 PwC Investment Powers Report, pp. 75 and 94.
the ucits iii product and design risks
161
on for hedging purposes; reliance on derivatives for leveraging was very
limited.190 Valuation risk was not regarded as significant.191 Liquidity risks
did not appear to be troubling,192 although liquidity and valuation risks
have increased with UCITS investing in non-liquid OTC derivatives.193
Asset managers also appear to be exercising some restraint and considering retail market suitability, as well as appropriate risk management
processes, before launching UCITS III schemes.194 The UCITS III product is also capable of decreasing retail investors’ exposure to market risk
through hedging techniques.195
On the other hand, the PwC study acknowledged that many UCITS
schemes are using alternative investment strategies and ‘to a certain extent,
have come to resemble hedge funds’ and highlighted that, as innovative and
sophisticated products are developed, the risks of mis-selling increase.196
Hedge-fund-like strategies are increasingly being imported into the UCITS
III product.197 Summer 2007 saw the first French UCITS scheme to replicate a hedge fund,198 while 2007 also saw UK schemes offering returns
based on equity market volatility through a UCITS III structure.199 In early
2008, the Irish regulator authorized schemes based on the FTSE Hedge
Global Index and the FTSE Hedge Momentum Index.200 Exchange-traded
schemes which track indices through derivatives have also increased.201
The flexibility of the UCITS III structure is well illustrated by the reported
move by hedge funds into UCITS III structures in early 2009 following
hedge fund investor demand for higher standards of investor protection,
liquidity and transparency.202 The perception of the UCITS as a low-risk
190
191
192
193
195
196
197
198
200
201
Derivatives exposure was generally linked to hedging (92 per cent of funds) and trading/arbitrage purposes (almost 50 per cent of funds): ibid., p. 71.
Ibid., p. 4.
The Report noted that fund-of-fund structures did not appear to have impacted on
liquidity risk (ibid., p. 66) although it noted the increased liquidity risk attendant on
investment in asset-backed securities in the wake of the subprime crisis (ibid., p. 69).
Ibid., p. 67. 194 Ibid., p. 7.
Over 2,000 schemes were developed which were designed to bet on, or insure against,
extreme volatility levels: K. Burgess, ‘Product Does More Than It Says on the Tin’, Financial
Times, Fund Management Supplement, 3 March 2008, p. 20.
2008 PwC Investment Powers Report, pp. 13 and 67.
S. Johnson, ‘Sophistication Goes Mass Market’, Financial Times, Fund Management Supplement, 5 November 2007, p. 1; and S. Johnson, ‘FSA Warns on Derivatives Danger’,
Financial Times, Fund Management Supplement, 11 February 2008, p. 1.
2008 PwC Investment Powers Report, p. 73. 199 Ibid., p. 74.
S. Johnson, ‘Dublin “Approves” Hedge Fund Indices’, Financial Times, Fund Management
Supplement, 25 February 2008, p. 2.
2008 PwC Investment Powers Report, p. 74. 202 Johnson, ‘Hedge Funds March’.
162
product regulation
investment product is changing internationally, with UCITS facing some
difficulties in those markets where UCITS are considerably more aggressive in their investment strategies than local schemes.203 While, in practice,
UCITS III products are often used as investment vehicles by the sophisticated investors204 who influenced the widening of investment powers
under the UCITS III regime,205 UCITS III schemes can be marketed to the
public and retailization can occur.
2. UCITS III and the risks of facilitative product design
a) Diversification
Diversification is of central importance in product regulation, given its
role in addressing general market risk and given that retail investors typically achieve diversification through products rather than through wider
asset allocation. Diversification benefits were repeatedly raised during the
UCITS III process. But the difficulties in achieving effective diversification through regulatory fiat (and the risks of regulatory promotion of the
UCITS) should not be overlooked as the UCITS product range becomes
more esoteric. The relatively crude UCITS diversification rules are linked
to limiting exposure to single issuers and to identifying the very wide range
of assets in which a UCITS can invest. They are not linked to factors more
likely to impact on diversification and returns, such as the degree of concentration in particular industry sectors206 or in particular asset classes;207
UCITS asset allocation rules would not have protected investors from
exposure to the dotcom sector during the early twenty-first-century market crash.208 Neither did the UCITS regime protect investors from market
risk related to over-exposure to the bond or money markets through specialist bond schemes as the ‘credit crunch’ deepened, although overall the
UCITS sector proved reasonably resilient, as discussed below.
Considerable scepticism as to the value of prescriptive asset allocation
rules can be seen in the FSA’s recent review of the listing rules which
203
204
205
206
207
S. Johnson, ‘How UCITS Became a Runaway Success’, Financial Times, Fund Management
Supplement, 27 November 2006, p. 3.
EFAMA, Annual Asset Management Report 2008, pp. 16–17. PwC also reported that UCITS
vehicles are extensively distributed to institutional investors (2008 PwC Investment Powers
Report, p. 96).
Asset managers in France and elsewhere pressed for the wider UCITS III powers in part to
meet the needs of the institutional market: R. Saunders, ‘What’s Right or Not for Ordinary
Investors’, Financial Times, Fund Management Supplement, 14 January 2008, p. 6.
Roe, ‘Political Elements’.
Hu, ‘Illiteracy and Intervention’. 208 Deutsche Bank, EU Asset Management, p. 6.
the ucits iii product and design risks
163
apply to domestic, non-UCITS, listed investment companies or trusts. It
removed a previous ceiling of 20 per cent on investments in securities of
another issuer on the grounds that the ceiling restricted effective investment strategies, led to an over-emphasis on portfolio risk and that rigid
asset allocation rules were a ‘crude proxy’ for the adequacy of portfolio
diversification.209 It instead adopted a principles-based approach, based
on general risk-spreading requirements,210 the retention of governance
requirements in the form of board independence rules and disclosure
requirements.211 A similar, manager-centric, principles-based approach
was adopted in the 2008 reforms to the FSA’s domestic, non-UCITS, regulated CIS (NURS) regime to accommodate funds-of-hedge-funds. The
risks raised by investment in hedge fund assets were not addressed by
asset allocation requirements but, in the interests of supporting flexibility, innovation and effective retail investor diversification opportunities,
by investment manager competence and diligence requirements.212 In an
area of less potential toxicity, the ‘stakeholder’ CIS product is based on a
principles-based approach to asset allocation, rather than on prescriptive
rules, in an attempt to support innovation and avoid a rigid, rule-based
approach.213
Diversification and protection against general market risk is also prejudiced by the vulnerability of investment managers to bias, herding and
noise-trading and the risk that asset allocation can become too closely
allied to the benchmarks against which schemes are assessed.214 CIS managers are not immune from market mania and diversification rules will
provide little protection against poor asset allocation.215 UCITS managers are not, through the UCITS regime at least, placed under any fiduciary obligation to the UCITS investor (the depositary is the focus for
investor protection, although, even there, the regime does not construct a
209
210
211
212
213
214
FSA, Transparency Directive Implementation and Investment Entities Listing Review (Consultation Paper No. 06/4, 2004), pp. 66–7.
Listing Rule 15 requires that the trust or fund must invest and manage its assets in a way
which is consistent with its object of spreading investment risk (Rule 15.2.2).
The FSA argued that, once a vehicle is properly governed, transparent and actually delivers
a spread of investment risk, rules should not prescribe the investment strategies which
should or should not be pursued: FSA, Investment Entities Listing Review (Consultation
Paper No. 07/12, 2007), pp. 8–9.
The FSA proposed high-level ‘due diligence’ principles for the fund manager (linked to
FSA guidance and industry and international (including IOSCO) standards), particularly
with respect to hedge fund valuation: FSA, Consultation Paper No. 07/6, pp. 10–11 and
Consultation Paper No. 08/4, pp. 18–19.
HM Treasury, Consultation on ‘Stakeholder’ Savings and Investment Product Regulations,
p. 9.
Shleifer, Inefficient Markets, pp. 12–13. 215 Karmel, ‘Mutual Funds’, 926–7.
164
product regulation
relationship between the depositary and investors216 ), whether through a
best-interests-type obligation or otherwise. National rules, of course, may
impose such an obligation on the manager,217 and its application seems
to be accepted by the industry,218 but the weak tradition of investor action
through the courts (chapter 8) limits the extent to which investors can
seek redress where fiduciary rules and principles are breached.
Equity schemes remain dominant among UCITS schemes, representing 41 per cent of all UCITS schemes in 2005.219 Retail UCITS investors
exposed to equities accordingly suffered heavy market losses over the
‘credit crunch’.220 Nonetheless, the UCITS industry appears to have weathered the crisis without serious failures,221 despite the exposure of some
UCITS to money-market instruments, CDOs and derivatives. Although
scheme losses and outflows were significant,222 and the money-market
schemes which represent 15 per cent of UCITS assets were, like their
US counterparts, heavily affected,223 very few European schemes closed
216
217
218
219
220
221
222
223
Although the depositary is liable to UCITS unit-holders (and the management/investment
company) for any loss suffered by them as a result of an unjustifiable failure to perform
its obligations or for improper performance of obligations (Arts. 9 and 16).
On the UK position, which, with respect to the duty owed to investors in unit trusts
(shareholders in corporate schemes benefit from the fiduciary duties imposed on company
directors), is contested, see Benjamin, Financial Law, pp. 224–5.
EFAMA, A Code of Conduct of the European Investment Management Industry: High-Level
Principles and Best Practice Recommendations: A Discussion Paper (2006), p. 7 (recommending that the management company accept a fiduciary duty to the investor, although
vague as to its contours).
2008 PwC Investment Powers Report, p. 18. 22.8 per cent of schemes were balanced and
21.3 per cent were bond schemes.
While market losses were responsible for 77 per cent of the losses sustained by the European
UCITS industry, this proportion increased to 84 per cent for equity schemes: EFAMA,
Quarterly Statistical Release No. 36 (2008), p. 2.
An admittedly partisan Commission suggested that the UCITS regulatory framework had
‘proved very resilient’ and that no more than a handful of schemes closed or suspended
trading: European Commission, Press Release IP/09/126, 29 January 2008. Similarly, bar
those few UCITS associated with the Madoff fraud, ‘the UCITS structure has proved
scandal-free during the severe ructions of the past 18 months’: S. Johnson and B. Aboulian,
‘Convergence Strategy under Threat’, Financial Times, Fund Management Supplement, 16
March 2009, p. 1. The BaFIN noted limited impact on retail schemes (BaFIN, Annual
Report 2007–2008, p. 164), although the French AMF focused on risk controls and the
quality of disclosure (Annual Report 2007, p. 3).
By the third quarter of 2007, net outflows represented one-third of total sales from the
beginning of the year, with bond funds most heavily affected: CESR, Annual Report 2007,
p. 19. See also ch. 2.
EFAMA, Annual Report 2007–2008, p. 12. The de Larosi`ere Report also noted the contraction
of liquidity and the redemption difficulties faced by CISs invested in short-term banking
paper (and asset-backed commercial paper): de Larosi`ere Report, p. 26.
the ucits iii product and design risks
165
(four),224 only a few suspended redemption (twelve, of which four
reopened) and the investors affected were predominantly institutions and
high net worth individuals.225 The ‘credit crunch’ also saw schemes raise
liquidity levels, focus on counterparty risk and operational resilience, particularly with respect to depositary functions, and shift to less risky assets
in certain cases; reaction and intervention by EC regulators were generally
limited.226 But, while the scale of the ‘credit crunch’ and its impact on
all asset classes would have placed strains on any diversification strategy,
requirements to diversify across different asset classes might have provided
stronger protection against market risks; so too might have a closer focus
on product provider responsibilities (section III.4 below).
b) Allied risk management risks
Some heavy lifting is required of regulation which ‘markets’ more complex
retail market products with respect to effective ancillary risk management.
Although the 2008 PwC study seems positive, and while the ‘credit crunch’
does not seem to have caused undue difficulties, more aggressive strategies place more strain on internal controls and risk management. The
extent to which regulation can capture the complex and rapidly evolving
valuation and liquidity risks raised by derivatives and hedge-fund strategies is unclear227 and a particular risk for unsophisticated investors.228
Implementation of the 2004 Recommendation has been variable,229 particularly with respect to the measurement of the market and leverage
risks of sophisticated and ‘plain vanilla’ schemes,230 in respect of which
Member States have adopted different approaches.231 This has led to some
224
225
227
228
229
230
231
S. Johnson, ‘UCITS Outflows Soar in Q3’, Financial Times, Fund Management Supplement,
1 December 2008, p. 2, reporting some rationalization and cost-cutting but that the
industry remained broadly robust.
EFAMA, Annual Report 2007–2008, p. 9. 226 Ibid., pp. 10 and 11.
The FSA earlier warned that UCITS III management companies may not implement
appropriate risk management systems (Discussion Paper No. 05/3, p. 9) and later pointed
to the risks of increased derivative use: Financial Risk Outlook 2008, p. 49. It raised derivative
management risk again as a key risk for the asset management sector in 2009: Financial
Risk Outlook 2009, p. 65.
P. Skypala, ‘No Verdict Yet, in Advice vs Passive Debate’, Financial Times, Fund Management
Supplement, 19 May 2008, p. 6.
CESR, Implementation of the European Commission’s Recommendations on UCITS: Report
of the Review Conducted by CESR (CESR/05-302b, 2005).
Member States are recommended to adopt a differentiated approach for ‘non-sophisticated
UCITS’ and ‘sophisticated UCITS’, although limited guidance is given on these categories.
Sophisticated funds are to adopt more nuanced ‘value at risk’ approaches and apply stress
tests to manage risks related to abnormal market movements (recital 3.3).
CESR, Implementation, p. 7.
166
product regulation
institutional concern,232 although regulatory arbitrage does not appear
to be a risk.233 CESR is certainly doubtful as to the resilience of the
current risk management regime234 and has suggested risk management
principles.235
c) Investor understanding
Despite the empowerment flavour of the UCITS III regime, the risks
to investor understanding, exacerbated by the strength of the UCITS
brand, are considerable, as has been highlighted by the French and UK
regulators236 and FIN-USE.237 The UCITS III regime has also radically
increased the range of products which can be marketed under the UCITS
label, increasing the risks of investor confusion.238 Perception and expectation risks239 are therefore considerable, particularly where investors have
previously bought UCITS products. They are exacerbated as UCITS are
still treated as conservative, retail-investor-friendly products by regulation, and are designated as ‘non-complex’ products and eligible for nonadvised execution-only sales under the MiFID regime (Article 19(6));
paradoxically, simple derivatives are excluded from the regime as complex
products.240
d) Advice and distribution
But, while the UCITS III product can carry significantly high levels of risk,
this alone is not, particularly given the potential for higher returns and
232
233
234
235
236
237
238
239
240
European Parliament, Resolution on Asset Management (P6 TA-PROV(2007)0627, 2007)
(‘Klinz II Resolution’).
2008 PwC Investment Powers Report, p. 79.
Its credit crunch agenda included examination of the ‘orderly functioning’ of CIS (CESR
Press Release, 1 October 2008 (CESR/08-791, 2008)).
CESR, Risk Management Principles for UCITS (CESR/09-178, 2009). CESR suggested
that the harmonized regime was limited and that recent market turbulence called for a
comprehensive approach.
The Delmas Report warned that UCITS III schemes were ‘increasingly esoteric and difficult
to understand for the average investor and even the seller’ (p. 9), while the AMF warned of
the increasingly sophisticated products marketed under the UCITS brand: AMF, Response
to Green Paper on Retail Financial Services (2007), p, 6. The FSA has also raised concern
that retail investors may not have fully understood the impact of the UCITS III regime:
Discussion Paper No. 05/3, p. 7.
FIN-USE, Opinion on the European Commission Green Paper on the Enhancement of the
EU Framework for Investment Funds (2005), p. 2.
Oxera, Current Trends, p. xii, and suggesting that ‘too much choice might not be in the
investor’s best interests’ (p. xiii).
D. Langevoort, Managing the Expectations Gap in Investor Protection: The SEC and the
Post-Enron Reform Agenda (2002), ssrn abstractid=328080.
See further ch. 2.
the ucits iii product and design risks
167
protection against general market risk, an occasion for undue concern.
But the supporting distribution regime, to which trusting investors are
particularly exposed, must be robust. And considerable risks arise from
the loose mooring of the UCITS III product within the wider advice and
marketing regime and its failure, accordingly, to engage fully with the
vulnerable, trusting investor.
UCITS units may be sold without advice in execution-only sales (MiFID,
Article 19(6)), under a regime which was negotiated well before the full
extent of the UCITS III regime became clear and without any apparent
concern from the institutions as to the potential reach of UCITS investments – pointing to the dangers in product design where the boundaries
of the product shift. The execution-only regime is available for ‘noncomplex products’, a classification which is based on liquidity, valuation,
leverage and transparency requirements.241 Although the industry appears
to be developing non-UCITS retail market schemes in compliance with
these four principles,242 whether or not all UCITS III products meet
these requirements is not clear, although a preoccupation with these four
requirements is a feature of CESR’s approach to the level 3 eligible assets
regime. CESR certainly appears to have some doubts as to the appropriateness of some UCITS schemes for execution-only treatment.243
Risks also arise with advised sales. Although increased demand for
advice concerning UCITS has been predicted,244 the extent to which the
new MiFID suitability regime (which covers UCITS advice by MiFID
firms) will address the significant mis-selling risks associated with complex
UCITS III schemes is questionable,245 particularly given the severity of
commission risk and of the incentive risks generated by proprietary sales
(chapter 4). Distribution difficulties also arise with respect to disclosure.
Although MiFID imposes product disclosure obligations on investment
241
242
243
244
245
See further ch. 2.
Presentation by Schroders Investment Management, ‘Are Non-Harmonized Investment
Funds Ripe for the Retail Market?’, European Commission Open Hearing on Retail Non
Harmonized Funds, April 2008.
Although its suggestion in the course of the consultations on UCITS disclosure reform
that product providers be required to flag whether a UCITS was designed for sophisticated
investors met the robust response that all UCITS were retail products and were classified
as non-complex instruments for execution-only sales: EFAMA, Response to the CESR
Consultation Paper on the Content and Form of KII Disclosure for UCITS (2007), p. 7.
Investment Funds Green Paper, p. 5.
The extensive 2003 SEC hedge fund report pointed to the need for vigilance in monitoring
whether broker-dealers were meeting suitability requirements in advising on fund-ofhedge-fund products: SEC, Implications of the Growth of Hedge Funds: A Staff Report to the
SEC (2003), p. 99.
168
product regulation
firms, it does not require that a UCITS prospectus or summary prospectus
be provided at the point of sale (chapter 5). Questions also arise as to
the competence of advisers on the risks of UCITS III products where
appropriate disclosure is not provided by the product provider.
The initial development of the UCITS III regime occurred without reference to distribution and advice and before the MiFID discussions got
underway. Nonetheless, the disjunction between the two regimes246 points
to the dangers of product regulation and of the risks which arise where radical product reforms are not reflected in the supporting distribution and
advice regime. The need to consider how the UCITS product sits within
the EC’s disclosure and advice regimes was, however, recognized throughout the UCITS IV reform process, suggesting growing appreciation of
the holistic nature of investor protection.247 But the retail-investor-facing
UCITS IV reforms are, for the most part, directed to disclosure,248 which
remains a problematic retail market device.
3. Beyond UCITS III: alternative investments and product design risks
a) Retailization of alternative investment and its benefits
The extent to which product regulation can rapidly become obsolete and
also reflect tangled conceptions of retail investor competence is well illustrated by the alternative investments question. The UCITS III regime,
however problematic, appears all the more so as it excludes the range of
alternative investments currently experiencing retailization.249 Retail market interest in non-UCITS alternative investments, often initially developed for the institutional sector but ‘handed down’ to the retail sector,
and which typically carry greater liquidity, valuation, leverage and transparency risks, is increasing significantly.250 Assets under management by
non-UCITS schemes, including private equity, venture capital, real estate,
commodity and hedge funds, amount to almost 10 per cent of total assets
246
247
248
249
250
J.-P. Casey, Shedding Light on the UCITS–MiFID Nexus and the Potential Impact of MiFID
on the Asset Management Sector, ECMI Policy Brief No. 12 2008 (European Capital Markets
Institute, 2008). See also ch. 4.
E.g. ESC, Minutes, 3 March 2005.
Although one useful reform requires the UCITS to supply distribution systems with UCITS
disclosure (ch. 5).
Reviewed in the 2008 PwC Retailization Report.
E.g. the 2006 Oxera Report (which pointed to changes in retail market demand and a
commoditization of hedge-fund-type strategies: Oxera, Current Trends, pp. vi–vii); and
the 2008 PwC Retailization Report, suggesting that retail investors are being attracted to
these investments (at p. 15).
the ucits iii product and design risks
169
under management251 and alternative investment schemes are growing
strongly.252 Two asset classes in particular are drawing attention: real estate
investment funds,253 which have experienced considerable growth;254 and
hedge-fund-related products (including funds of hedge funds (FoHF))
which, while experiencing more modest growth,255 have attracted close
political and regulatory attention.
Alternative investments can deliver non-correlated and accordingly
stronger returns and can provide effective diversification.256 As highlighted in chapter 2, closer regulatory consideration of how to support
retail investor access to alternative investments, whether through product
strategies or otherwise, is therefore warranted given the scale of the market risk carried by investors. Reflecting an international focus on these
investments,257 the FSA (along with other Member States), although
somewhat sceptical of mass retail market engagement with alternative
investments,258 has expanded the permissible asset classes for its nonUCITS regulated schemes regime to include FoHFs and has accepted the
251
252
253
254
255
256
257
258
Investment Funds White Paper, p. 11. The 2008 PwC Retailization Report quantified the EC
market at €1.79 trillion in 2007 (up from €1.56 trillion in 2006): 2008 PwC Retailization
Report, p. 6.
European Commission, Financial Integration Monitor (2006) (SEC (2006) 1057), p. 19.
The main forms of collective property investment are real estate investment trusts or REITs
(in the form of companies, usually listed), closed-end real estate funds and open-ended
real estate funds.
The sector (real estate funds, rather than real estate trusts in the form of companies) represented €198 billion of assets under management in 2007, with retail investors representing
a ‘moderate’ level of activity at 24 per cent: 2008 PwC Retailization Report, pp. 6 and 13.
IOSCO has highlighted significant growth in this area and called for it to be kept ‘under
close watch’: IOSCO, Review of the Regulatory Issues Relating to Real Estate Funds (IOSCO,
2008), p. 2.
While hedge-fund-like products are increasingly being made available to the ‘mass affluent’
(PricewaterhouseCoopers, The Regulation and Distribution of Hedge Funds in Europe
(2005) (‘2005 PwC Report’), p. 2), including through UCITS III products, levels of FoHF
investment remain relatively low: 2008 PwC Retailization Report (reporting that retail
investors represent only 1 per cent of hedge fund investment and 10 per cent of FoHF
investment (at p. 13)).
As acknowledged by the FSA: Financial Risk Outlook 2007, pp. 6–7 and 49.
The FSA has highlighted a ‘general international acceptance that advances in investment
management techniques make [FoHFs] appropriate for the retail environment’: Consultation Paper No. 07/6, p. 7. IOSCO, in particular, has closely examined FoHF risk: Consultation Report – The Regulatory Environment for Hedge Funds: A Survey and Comparison
(IOSCO, 2006); Report on Funds of Hedge Funds (IOSCO, 2008), and Proposed Elements
of International Regulatory Standards on Funds of Hedge Fund Related Issues Based on Best
Market Practice: Consultation Report (IOSCO, 2009).
‘[T]hese alternative investments are likely to be suitable only for a minority of consumers
who understand the risks involved and then usually as part of a diversified portfolio’:
Financial Risk Outlook 2005, p. 46.
170
product regulation
consequent liquidity constraints259 given the potential for diversification,
stronger returns and wider choice.260
Investments in real estate schemes are regarded as offering a good
balance between risk and return and as providing effective diversification as these schemes are not correlated to market returns. They may
also be considerably less risky than UCITS III products – although, as
recent convulsions in the property market have made clear, not always.261
Direct hedge fund investment is an unwelcome distraction for retail market policy. While the liquidity, transparency, complexity, market, costs,
valuation and incentive risks (given the structure of manager remuneration) to investors are very considerable,262 hedge funds do not normally welcome retail investors. Investment thresholds, whether by way of
fund practice or by law, are typically very high.263 FoHFs are exposed to
hedge fund risk in relation to the underlying hedge fund assets. The additional risks to retail investors, who can access FoHF products more easily,
include poor due diligence by the manager,264 excessive remuneration
costs and conflict-of-interest risks as FoHFs adopt similar fee structures
to hedge funds, fraud risks given their opacity and complexity, overall
259
260
261
262
263
264
The FSA’s proposed regime allows funds of alternative investment funds to impose limited redemption periods, although funds must redeem once in every six-month period:
Consultation Paper No. 07/6, p. 13.
Ibid., p. 3. In its earlier discussion paper, the FSA emphasized the danger that investor
choice could be restricted were ‘wider range’ or alternative investments not supported:
Discussion Paper No. 05/3, p. 23.
The FSA has highlighted the redemption deferrals required by property funds following
mass withdrawals which may have arisen as investors did not understand the funds’
characteristics: Financial Risk Outlook 2008. Temporary suspensions have also occurred
elsewhere, notably in Germany in 2005–6.
E.g. H. McVea, ‘Hedge Funds and the New Regulatory Agenda’ (2007) 27 Legal Studies
709; N. Moloney, ‘The EC and the Hedge Fund Challenge: A Test Case for EC Securities
Policy after the Financial Services Action Plan’ (2006) 6 Journal of Corporate Law Studies
1; and Karmel, ‘Mutual Funds’.
Industry feedback to the Commission’s December 2008 consultation on hedge funds, for
example, highlighted the widespread view that retail investor exposure to hedge funds was
not a positive development and that any moves to support access should be accompanied
by strong safeguards: DG MARKT, Feedback Statement on Hedge Fund Consultation (2009),
p. 18.
The 2008 Madoff scandal and the US$50 billion losses sustained by many FoHFs pointed
not only to regulatory failure by the SEC, but also to a failure of due diligence by FoHF
asset managers: Financial Times, Lex Column, 16 December 2008, p. 16. Retail investors
in France and Spain suffered exposure to the Madoff fraud through FoHF investments: D.
Ricketts, ‘Mutual Funds Move Back into the Black’, Financial Times, Fund Management
Supplement, 19 January 2009, p. 11.
the ucits iii product and design risks
171
liquidity265 and valuation risks and failures in disclosure. But, and, in a
very significant assumption, assuming appropriate due diligence by and
effective regulation of the FoHF manager266 (and particularly if, in the
wake of the ‘credit crunch’, more extensive regulation is imposed on the
underlying hedge funds with respect to valuation and liquidity risks267 ),
FoHFs may provide investors with stronger market returns and better
diversification opportunities. They may also deliver stronger returns than
the very complex proxies (including UCITS III schemes which invest in
hedge fund indices) which UCITS product regulation has produced.268 The
EC’s willingness to allow UCITS III schemes to invest in what can often be
unstable, derivative-based and highly complex hedge fund indices,269 but
its reluctance to engage with what can be more straightforward FoHFs,
not only suggests some regulatory incoherence. It also suggests a muddled
view of retail market risk, which is also evident in the exclusion of ‘plain
vanilla’ derivatives from execution-only services under MiFID.270
A controlled extension by the EC of the retail product regime to
include alternative investments has some attractions. The empowerment/
265
266
267
268
269
270
As became clear during the credit crunch as FoHFs imposed redemption restrictions: B.
Aboulian, ‘Liquidity Tightening Now on the Agenda’, Financial Times, Fund Management
Supplement, 12 January 2009, p. 11.
IOSCO has produced standards to support adequate due diligence by the manager, particularly with respect to the quality of valuation by the underlying fund and liquidity
risks (n. 257 above; and H. McVea, ‘Hedge Fund Asset Valuations and the Work of the
International Organization of Securities Commissions (IOSCO)’ (2008) 57 International
and Comparative Law Quarterly 1), while the FSA’s guidance and rules for FoHFs similarly
focus on manager due diligence.
The EC is moving in this direction, despite considerable institutional tensions, with a
Commission consultation on hedge funds launched in the wake of the autumn 2008
convulsions in December 2008 and a subsequent proposal for a Directive on Alternative Investment Fund Managers (COM (2009) 207). The proposal seeks to impose
standards on the managers of alternative investment schemes and to provide them
with a marketing passport for their alternative investment schemes; the passport will
be restricted to cross-border marketing to professional investors only. Hedge fund reform
has also been identified by the G20: London Summit – Leaders’ Statement, 2 April 2009,
para. 15.
Hedged/long-short mutual funds typically under-perform hedge funds: V. Agarwal,
N. Boyson and N. Naik, Hedge Funds for Retail Investors? An Examination of Hedged
Mutual Funds (2006), ssrn abstractid=891621.
The Alternative Investment Management Association has expressed concern as to UCITS
III investment in hedge fund indices and suggested that FoHFs are a better vehicle for
retail investment: P. Skypala, ‘Hedge Fund Indices Access Likely’, Financial Times, Fund
Management Supplement, 12 February 2007, p. 2.
The European Parliament has criticized the exclusion of FoHFs and REITs from the
UCITS III regime which accommodates ‘fairly volatile and less transparent assets’: Klinz
II Resolution.
172
product regulation
responsibilization model, to be internally consistent, suggests that, if
investors are to take on more responsibility, they should not be restricted
from investment strategies which promise stronger returns and better
diversification,271 even if advanced regulatory technology is required. The
rate at which market convulsions occur, and the repeated exposure of regulatory failures, might even call for the ‘alternative’ brand to become otiose
and for regulators to focus on how the retail sector can efficiently hedge and
protect against market risk. The current emphasis on capability also suggests that retail investors should be exposed to learning opportunities.272
Neither should the trusting investor be excluded from the opportunity to
learn and generate stronger returns, although this investor requires considerably more of regulation than facilitative product regulation; serious
attempts must be made to engage with the potential for product design,
investor confusion and distribution risks which the UCITS III regime has
exposed.
The siren call of investor choice might also suggest that a pan-EC
alternative investment product, whether through extension of the UCITS
regime or in the form of a discrete vehicle, might be warranted. While
a range of alternative investment products are available in local markets,
they do not benefit from a cross-border passport. Retail investor choice is
therefore restricted,273 as is competition in the investment product market;
extending the regime might, therefore, ‘enrich fund offers’ to investors.274
b) The risks
It is not clear that retail investors are prejudiced by the UCITS III limitations. Retailization of non-UCITS schemes remains limited.275 Member
States already have in place tailored non-UCITS regulatory regimes which
support the public marketing of domestic non-UCITS schemes, particularly property funds,276 and which reflect local preferences and demand.
271
272
273
274
275
276
H. Shadab, ‘Fending for Themselves: Creating a US Hedge Fund Market for Retail Investors’
(2008) 11 New York University Journal of Legislation and Policy 252.
The FSA has queried whether restrictive product regulation might inhibit investors in
learning about the full range of investment products: Discussion Paper No. 05/3, p. 23.
2008 PwC Retailization Report, pp. 8–9 and 15 (particularly as Member States tend to
adopt an ‘equivalence’ approach to access which, given the differences among schemes,
and differing regulatory perceptions of product risk, can restrict cross-border access).
Commission, UCITS IV Impact Assessment, p. 10.
As the 2008 PwC Report, which also recommended that a harmonized non-UCITS market
would not significantly benefit retail investors, concluded: 2008 PwC Retailization Report,
p. 16.
Property funds, for example, can be authorized in the UK under the FSA’s NURS regime.
the ucits iii product and design risks
173
Hedge fund investment has also been addressed in a number of Member
States, particularly through FoHF vehicles.277 The UCITS III product may
also meet demand for alternative investments.278
Low levels of financial capability call for caution before any attempt
is made to give more risky investments, with additional liquidity, leverage, valuation and transparency risks, some type of quality label through
authorization devices. The UCITS III injection of greater risk into the
retail investment product market does not suggest that the retail market
is well equipped to cope with an expansion in the range of ‘riskier’ but
authorized products. CESR adopted a robust approach to retail investor
risk which colours the level 2 and level 3 regimes, but the related consultations shed unforgiving light on the extent to which the industry dominated
discussions.279
Effective regulatory design may also be difficult to achieve280 given
the febrile and highly politicized debate which has accompanied hedge
fund retailization in particular.281 The gulf between retail and industry concerns is all too clear in the 2006 clash between FIN-USE and
277
278
279
280
281
2005 PwC Report.
2008 PwC Retailization Report, p. 15, suggesting that non-UCITS strategies were becoming
‘retailized’ through the UCITS III product.
E.g. CESR’s 2004 Call for Evidence on the Level 2 Eligible Assets regime elicited fifteen
responses, many from trade associations, all from the industry sector, and all in support
of increased choice for fund managers: CESR, Level 2 Eligible Assets Consultation Paper
(CESR/05-064b, 2006), Annex A, pp. 45–7. CESR’s Issues Paper on the treatment of
hedge fund indices generated twenty-two responses, all from the industry sector: CESR,
Consultation Paper on Hedge Fund Indices (CESR/07-045, 2007), p. 7.
The SEC has struggled with hedge fund regulation and been heavily criticized for
its ill-fated attempts to address retailization risks by regulating hedge fund managers:
T. Paredes, On the Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy,
Style, and Mission (2006), ssrn abstractid=893190.
The European Parliament has repeatedly called for hedge fund intervention. While its 2008
Resolution on hedge funds and private equity accepted the role of hedge funds in supporting market efficiency, it also highlighted the stability, transparency and valuation risks
and called on the Commission to consider a regulatory response (European Parliament,
Resolution with Recommendations to the Commission on Hedge Funds and Private Equity
(P6 TA-PROV 0425, 2008). The Resolution was followed by calls from leading MEPs for
the resignation of Commissioner McCreevy for his failure to bring forward proposals.
An earlier contribution from the Parliament’s Socialist Group (Hedge Funds and Private
Equity – A Critical Analysis (2007)) heavily criticized market economy principles in its
discussion. On the EC hedge fund debate, see further N. Moloney, EC Securities Regulation
(2nd edn, Oxford: Oxford University Press, 2008), pp. 333–5; and P. Athanassiou, Hedge
Fund Regulation in the European Union: Current Trends and Future Prospects (Kluwer Law
International, 2009).
174
product regulation
the Commission’s Expert Group on Alternative Investment.282 Governance risks are also acute given the under-representation of retail interests
in policy development; the Commission’s 2008 Open Hearing on nonharmonized retail market funds saw broad support for greater retail access
to non-harmonized schemes but, with a few exceptions, was dominated
by the industry perspective and calls for easier industry access to the retail
markets.283
Adventures in product design are rewarding for the industry if the
brand benefits of the UCITS III product can be stretched. They are also
more appealing for policy-makers than the hard work required to make
distribution and disclosure regimes fit for purpose and to ensure product
providers develop appropriate products. But they distract policy attention
from more fundamental and intractable questions concerning the retail
product market. The real retail market risk lies in the failure of the industry to develop, test and provide transparent and investor-facing products
which support long-term savings, manage market risks and reflect investor
needs. And, as long as distribution remains closely tied to proprietary product providers, or, as it ‘opens’, exposed to commission risks, mis-selling
risks remain. Any incentives to construct ever more complex products may
simply further misalign retail investor and industry interests. While efforts
to support retail access to alternative investments are important given the
significant market risk carried by vulnerable but engaged trusting investors
and by more independent empowered investors, they demand very careful
regulatory design across a number of dimensions.
282
283
The Report called for a ‘rational and dispassionate debate on the conditions under which
retail access to hedge-fund-based investments could be contemplated’, and argued that
retail investor access ‘should no longer be a taboo’: Report of the Alternative Investment
Expert Group, Managing, Servicing, and Marketing Hedge Funds in Europe (2006), p. 6.
FIN-USE was ‘alarmed’ by the Group’s view that MiFID could support the distribution of hedge funds without further restrictions at the level of the fund, its managers
or elsewhere in the value chain, save for a €50,000 investability threshold: FIN-USE,
Response to the Report of the Alternative Investment Expert Group – Managing, Servicing,
and Marketing Hedge Funds in Europe (2006), p. 1. Earlier, it warned that ‘any significant opening of the retail mass market to these new products would raise very large
questions about effective consumer protection’: FIN-USE, Opinion on the European Commission Green Paper on the Enhancement of the EU Framework for Investment Funds,
p. 11.
Commission, Report on the Open Hearing on Non-Harmonized Funds (2008). Similarly,
none of the seventeen responses to the Expert Group on Open-Ended Real Estate Funds
represented retail interests (although three regulators responded) and all the responses
supported the construction of a passportable vehicle.
the ucits iii product and design risks
175
c) Designing a response
Although the empowerment and choice model appears to have a strong
supporter in the Parliament,284 the Commission, hearteningly, appears
cautious285 (not least given the liquidity problems experienced by the
alternative sector over the financial crisis286 ). It is concerned to take a
‘sound and empirically based’287 decision, and an extensive consultation
process has taken place. In addition to the consultation rounds which
accompanied the 2005 Green and 2006 White Papers on investment funds,
it included the 2006 report of the Commission-appointed Expert Group
on Alternative Investment, the 2008 Open Hearing on non-harmonized
retail markets funds and the 2008 report of the Commission-appointed
Expert Group on Open Ended Real Estate Funds.288
Initial efforts have focused on real estate investment funds which are
well established across the EC and may often be more low-risk than UCITS
III products. The 2008 Expert Group Report recommended that a passport and accompanying regulatory scheme be developed for open-ended
real estate investment funds. But, while granting a passport to property
schemes might provide additional diversification opportunities, caution is
warranted. Liquidity risks are considerable.289 To the extent that local market appetite exists, industry and local regulators have already responded
in many Member States. Developing a passportable vehicle might also
suggest trend-chasing risks, given the recent high returns in the property
sector which have since collapsed.290 The UK experience with split-capital
284
285
286
287
288
289
290
Committee on Economic and Monetary Affairs, The Future of Hedge Funds and Derivatives
(A5-0476/2003, 2003), pp. 6 and 8–10. The Parliament’s 2007 Klinz II Resolution also called
on the Commission to address wider investor access, and argued that the exclusion of openended real estate investment trusts and FoHFs from the UCITS regime was limiting the
diversity of investment products available to retail investors.
Commissioner McCreevy suggested that any move to address non-harmonized retail funds
would require assessment of whether demand existed, whether these funds were really retail
products given their risk/return profile, and much greater understanding of the sector:
Commissioner McCreevy, Speech on ‘Fulfilling the Promise of Europe’s Asset Management
Industry’, 24 November 2006, available via http://europa.eu/rapid/searchAction.do.
Skypala, ‘Squabbling’.
European Commission, Investment Funds White Paper, p. 12.
Expert Group Report, Open Ended Real Estate Funds (2008).
Skypala, ‘Squabbling’. The Report acknowledged that open-ended real estate funds are
vulnerable to mass redemptions and to the risks attached to rapid liquidation of illiquid
property assets but suggested that this could be managed by liquidity management and
regulatory devices such as deferral and suspension mechanisms: Open-Ended Real Estate
Funds.
The Report acknowledged that the real estate market performed ‘particularly well’, as
compared to other asset classes, during the review period: ibid., p. 15.
176
product regulation
trusts is instructive. ‘Split caps’ were listed investment trusts with different
classes of shares which were designed to reflect different investment objectives. They had complex structures and high levels of gearing and were
heavily marketed to the retail sector. While a long-established investment
vehicle, they increased rapidly in complexity and expanded rapidly over
the dotcom equity market boom.291 As the market fell, large-scale investor
losses were sustained as severe stresses were placed on the trusts from their
high levels of borrowing (lending covenants were breached as the trusts’
asset value dropped) and their cross-holdings in other trusts.292 Although
the FSA responded with regulatory reforms,293 the scale of the losses and
the failure of the regulatory regime to predict the risks caution against
regulatory support for products where the risks may not yet be entirely
clear and the supporting distribution, disclosure and financial capability
structures are shaky; a similar lesson might be drawn from the emerging
problems with the marketing of structured retail investment products.294
4. Beyond product regulation: the product provider and the
provider/distributor relationship
Given the difficulties in the CIS product market, it might be asked whether
closer attention should be paid to the product provider. The 2008 PwC
study on UCITS investment strategies suggests some discipline in the
UCITS III sector with respect to marketing to the retail sector, but this is a
matter of self-regulation. The UCITS regime focuses almost entirely on the
structure of the UCITS product. It does not – and in this it reflects international practice – require that product providers consider whether a particular product, while UCITS III-compliant, reflects retail investor demand
and investor competence295 or simply repackages a product designed for,
291
292
293
294
295
The sector grew from £5.78 billion in 1980 to £49.5 billion in 2002: FSA, Split Capital
Investment Trusts: Update Report on the FSA’s Enquiry into the Split Capital Trust Market
(Policy Statement, 2002) (‘Split Capital Trusts Statement’), p. 4.
Risks to investors became ‘exponential’ as the gearing effect multiplied the risks, the effects
of falling markets magnified, and it became difficult to unwind fund positions: ibid.,
pp. 5–6.
Targeted reforms to ‘split caps’, including board independence requirements and a prohibition on investment in schemes which were not subject to a prohibition on investments
of more than 15 per cent of scheme assets in other schemes, followed.
J. Hughes, ‘Products Backed by Lehman Spark FSA Probe’, Financial Times, 8 May 2009,
p. 3.
Regulators generally do not impose requirements on the product design process: Basel
Committee on Banking Supervision, International Organization of Securities Commissions, International Association of Insurance Supervisors, Customer Suitability in the Retail
the ucits iii product and design risks
177
and trialled in, the institutional sector.296 It does not require that particular
retail investor weaknesses, particularly diversification, or vulnerabilities,
particularly with respect to market risk, be addressed. Neither does the
regime address the provider’s choice of distribution channel, although this
choice dictates the extent to which riskier products are distributed to the
public and has implications for the quality of advice and the extent to
which advisers ‘know their products’.
But – and reflecting the contrast between EC investor protection rules
‘on the books’ and the nuance which can be delivered by domestic regimes
‘in action’ – product design and distribution-selection is being addressed
in some national markets.297 The Delmas Report, for example, called
for more careful delineation of producer and distributor responsibilities,
highlighted failures to target products appropriately,298 and suggested that
product providers identify the savings needs which products were designed
to meet.299 It recommended that products be segmented into ‘standard
products’ (designed to meet basic savings needs and including indexed or
guaranteed equity schemes) and ‘diversified products’ (designed to offer
more advanced investment options) in order to support more carefully
targeted marketing and to facilitate the sales and advice process.300
In the UK, the FSA’s ‘law in action’ Treating Customers Fairly
(TCF) initiative has been applied to the ‘product life cycle’ and to
the respective responsibilities of product providers and distributors.301
Related FSA Guidance also addresses product provider and distributor
responsibilities302 and focuses on the TCF Outcome that products and
services marketed and sold in the retail market be designed to meet the
296
297
298
301
302
Sale of Financial Products and Services (Bank for International Settlements, 2008) (‘Joint
Forum Report’), p. 22.
‘Hand-me-down’ products, not tested in the retail market, are a growing concern for
the FSA: Financial Risk Outlook 2009, p. 64; and D. Waters (FSA), Speech on ‘Current
Regulatory Issues and Challenges for the Funds Industry’, 14 November 2007, available
via www.fsa.gov.uk/Pages/Library/index.shtml.
The US regime also has some experience in this area, with FINRA guidance on product
design for complex products: Joint Forum Report, p. 22.
Delmas Report, pp. 9–10 and 40. 299 Ibid., p. 24. 300 Ibid., p. 30.
FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers
(Discussion Paper No. 06/4, 2006); and FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers (Policy Statement No. 07/11, 2007). Detailed
examples of good practice are also set out in FSA, Treating Customers Fairly in Product
Design (2007) and a TCF ‘cluster report’ (FSA, Product Design: Considerations for Treating
Customers Fairly) which has been supported by 2005 and 2006 case studies.
Regulatory Guide, annexed to Policy Statement No. 07/11. It covers the responsibilities
of providers (with respect to product design, information to distributors and customers,
selection of distribution channel and post-sale responsibility) and distributors (marketing,
178
product regulation
needs of identified consumer groups and targeted appropriately (TCF
Outcome 2). It provides guidance on how firm processes can be used
to support better product design including with respect to: the design
of products for target markets (which should be based on a clear understanding of the needs and financial capability of the target group); product
stress testing;303 and the management of product design risks.304 The FSA
has also focused on product providers’ choice of distribution channels
and suggested that providers should consider whether investors should
seek advice; they should also examine distribution patterns in practice.305
The FSA is also concerned as to problems at the provider/distributor
interface306 and has recommended that providers ensure that information
is sufficient, appropriate and comprehensible.307
But product provider strategies may deepen the risks posed by product
regulation as they involve the regulator engineering further into the design
process; the FSA has produced a regime of very considerable prescription
which is ‘hard-wired’ into the design and testing of investment products.
The TCF regime calls on sophisticated regulatory technology and significant supervisory resources, but success has been elusive. Although some
positive outcomes have been recorded, outcomes have been variable, particularly with respect to the identification of target markets;308 commercial
incentives are such that some very heavy lifting is required to drive product providers to produce clear and appropriately targeted products. But
the difficulties do not detract from the ambition of the strategy and its
concern to get to the root of poor product design. This ‘in action’ model
is some considerable distance from the EC’s UCITS III regime.
This is not to suggest that the Delmas or FSA strategies be incorporated into the EC regime, not least as they are rooted in local market
experience. But they do shed some unforgiving light on the limitations
of the UCITS regime and the challenges posed by product regulation
303
304
306
308
disclosure, advice and post-sale responsibility). It is supported by good practice illustrations for product providers: FSA, Treating Customers Fairly and UK Authorized Collective
Investment Schemes – Good Practice Illustrations (2008).
Products should also be stress-tested to identify how they perform in a range of different
market environments and how the target investor(s) might be affected: for example, FSA,
Discussion Paper No. 06/4, Annex I, p. 6.
Regulatory Guide, para. 1.17. 305 Ibid., para. 1.20.
FSA, Policy Statement No. 07/11, p. 10. 307 Regulatory Guide, para. 1.18.
The FSA has reported that, while progress had been made, more work was required with
respect to identifying target markets, stress-testing, adequate systems and controls and
producing appropriate information: Treating Customers Fairly in Product Design, pp. 1
and 4.
structured and substitute products
179
‘in action’. CESR may have a role to play, particularly as experience with
national models emerges, by establishing guidance in this area. There are
also some signs that the industry might not resist a ‘life-cycle’ model. The
European Fund and Asset Management Association’s (EFAMA) Code of
Conduct recommends that management companies take reasonable care
that their schemes are sold through distributors who meet the Code’s
standards, that an appropriate product information framework is developed between the distributor and the management company and that the
distributor is monitored.309 In the more febrile structured retail products
context, efforts have also been made to address the design process and the
provider/distributor relationship, with a group of leading trading associations (through their Joint Associations Committee (JAC)) producing
Standards in 2008 for the management of the product provider/distributor
relationship.310 Like the EFAMA Code, the Standards echo, if somewhat
faintly, the FSA’s ‘life-cycle’ approach. A similar effort in the Netherlands
has seen some industry concern to engage with the risks posed by the
product design process and poorly targeted products.311 The resilience of
the JAC Standards is doubtful in that they are non-binding312 and short on
detail; the FSA appears sceptical as to their effectiveness.313 Nonetheless,
the appearance of design elements in industry codes points to an emerging concern to address design risks by means other than formal product
regulation.
IV. Structured and substitute products
1. The substitute product market and structured products
a) Substitute products
The risks of product regulation have recently been brought into sharp
relief by the rapidly emerging risks from products which are substitutable
with, or comparable to, the heavily regulated UCITS.
309
310
311
312
313
EFAMA, Code of Conduct (2006), pp. 19–20.
Joint Association Committee, Retail Structured Products: Principles for Managing the
Provider–Distributor Relationship (2008).
The Dutch Banking Association (the NVB) has adopted an ‘urgent recommendation’ to
banks to consider the product’s profile, its risks, the expected returns, different scenarios
(including ‘bad weather scenarios’) and the target market: AFM, Exploratory Analysis of
Structured Products (2007), p. 39.
They are designed to ‘help inform firms’ thinking’: Joint Association Committee, Retail
Structured Products: Principles for Managing the Provider–Distributor Relationship, p. 1.
FSA, Policy Statement No. 07/11, p. 15.
180
product regulation
The Community savings market is experiencing rapid growth in the
range of products which can deliver market-linked returns.314 Market
returns and leverage are no longer the preserve of UCITS, as is reflected in
the pre-financial crisis outflows from the European CIS industry,315 but
can be achieved through a range of products. These can be broadly classified as unit-linked life insurance products, locally regulated non-UCITS
CISs (in particular, property schemes and investment trusts), deposits
with investment components (structured deposits) and other structured
products or securities.
Unit-linked insurance products, which provide a market-based return
based on the performance of an underlying asset pool, dominate as savings
vehicles in the Community, although investment patterns vary,316 and are
experiencing strong growth.317 The risks to the retail sector are similarly
increasing; massive growth in the unit-linked product sector in a number
of Member States in the late 1990s left many retail investors, who had
not appreciated the risk transfer to policyholders, exposed in the dotcomrelated equity market downturn and led to particular concern in the
Netherlands.318
Non-UCITS closed-end investment trusts and companies also account
for a significant portion of the investment product market, with investment
trusts representing a significant proportion of the London Stock Exchange,
for example. Together, the UCITS/CIS, unit-linked life insurance and
structured product market is valued at more than €10 trillion and sees net
sales of nearly €500 billion annually.319
b) Structured products
But it is the recent explosive growth in retail market structured products320
which has heightened the policy focus on substitute investment products.
314
315
316
319
320
EFAMA, Response to Commission’s Call for Evidence on Substitute Products (2007), p. 1.
Outflows reached €137 billion in the 12–18 months prior to summer 2008: P. Skypala,
‘What Does Brussels Really Want?’, Financial Times, Fund Management Supplement, 14
July 2008, p. 6 (citing Lipper Feri). Net sales of UCITS fell by 5 per cent in 2006, while
sales of structured products and unit-linked insurance products rose by 18.5 per cent and
50 per cent, respectively: Commission, UCITS IV Impact Assessment, p. 10.
See further ch. 1. 317 BME Report, p. 66. 318 Joint Forum Report, pp. 76–7.
Commission, Need for a Coherent Approach to Product Transparency and Distribution
Requirements for ‘Substitute’ Retail Investment Products (2008) (‘Need for a Coherent
Approach’), p. 8. By the end of 2008, the market was estimated at €8–10 trillion in the
European Commission’s impact assessment for the Packaged Products Communication:
SEC (2009) 556 (‘Packaged Products Impact Assessment’), p. 43.
Retail market ‘structured’ products are different to the ‘structured’ debt instruments
strongly associated with the financial crisis, although some retail structured products have
structured and substitute products
181
Like alternative investments, structured products do not form a discrete
product class.321 They are typically, although not always, bonds issued
by specialist vehicles, the return on which is derived from a range of
underlying or embedded assets, including securities, indices,322 foreign
exchange,323 commodities, derivatives or debt and combinations thereof.
Product design, rather than asset management, dictates the risk/return
profile. Structured products can also take the form of bank or term
deposits, the yield from which is calculated by reference to the performance of different indicators.
The European retail market, which was valued at €136.9 billion in 2005,
an 11.1 per cent increase on 2004,324 and which represents approximately
two-thirds of the global market and far outstrips the US market,325 has
recently experienced explosive growth, reflecting retail investors’ search
for yield in a low interest environment326 as well as their demand for tailored products which reflect different savings needs.327 Growth has also
been linked to greater demand for alternative and more short-term savings
products from retired investors in particular.328 European growth is being
driven by the mass retail market which accounted for 79 per cent of total
sales in 2005 and by active retail trading on specialist trading markets.329
Growth has not, however, been uniform across the EC and is concentrated
in Italy and Spain, although there has been considerable growth in the
321
322
323
324
325
326
327
329
been based on underlying CDO structures, typically the AA or AAA tranches: ‘Credit Risk:
Retail CDOs’ 18 Risk, No. 4 (April 2005), available via www.risk.net/public/. The potential
confusion in terminology has been associated with a potential reduction in retail investor
demand: ‘How Retail Investors Are Influencing Structured Products’ in KPMG, The State
of the Investment Management Industry in Europe (2008), p. 22, p. 23.
J. Benjamin and D. Rouch, ‘Providers and Distributors: Responsibilities in Relation to
Structured Products’ (2007) 1 Law and Financial Markets Review 413.
Equity- and index-linked products dominate in the European market, representing 61.3
per cent of the retail market in 2005: Soci´et´e G´en´erale, The European Retail Structured
Investment Product Market: Panorama and Trends (2006) (‘Soci´et´e G´en´erale Report’), p. 8.
Particularly in Germany: Deutsche Bank Presentation, Retail FX – Overview, Implications, and Discussion, ECB Foreign Exchange Contact Group, March 2006, available via
www.ecb.int.
Soci´et´e G´en´erale Report, p. 5.
BME Report, pp. 59–60. The US market is roughly half the size of the European market,
although structured products are becoming popular: J. Bethel and A. Ferrell, Policy Issues
Raised by Structured Products (2007), ssrn abstractid=941720.
Joint Forum Report, p. 5.
FSC Report, p. 20. 328 Bethel and Ferrell, Policy Issues, p. 22.
The European Warrant Exchange, Europe’s largest exchange for securitized derivatives,
specializes in retail investor products and experiences high levels of retail trading:
M. Burghardt, M. Czink and R. Riordan, Retail Investor Sentiment and the Stock Market (2008), ssrn abstractid=110038, p. 13.
182
product regulation
Netherlands,330 Germany331 and France.332 The UK market lags considerably behind, although it is growing.333 The market is also characterized
by a concentration of different products in different national markets.
Warrants, which give the investor the right to buy or sell the underlying
asset at a specified price and within a specified time-frame, have experienced strong growth in Germany,334 although they are rare elsewhere,335
while index-linked/tracker bonds have enjoyed considerable growth in the
Danish retail market.336
As is regularly acknowledged by regulators, structured products can
offer attractive returns and allow retail investors diversified and hedged
access to assets337 (and combinations of assets) which may not otherwise
be available, particularly in the commodities and derivatives markets.338
They accordingly provide some protection against market risk. They also
provide investors with opportunities for increased gains (and increased
risks) through leverage. Conversely, the capital protection associated with
these products has proved to be particularly popular with risk-averse
investors339 and makes them attractive products for investors close to
retirement;340 capital protection led to strong growth in the market in the
wake of the 2002–3 equity market downturn.341 A spectrum of investor
needs can therefore be met.
The risks are, however, considerable. Many Member States, reflecting policy support for a widening of the range of investments available to empowered retail investors, have adopted tailored and supportive
330
331
332
333
334
335
336
337
338
339
340
AFM, Annual Report 2006, pp. 44 and 48. Retail investor holdings in structured products
increased from €3 billion in 2003 to €30 billion by the end of 2006, with one investor in
three (500,000 households) holding structured products (p. 48).
BaFIN, Annual Report 2005, p. 34. and Annual Report 2006, p. 27.
Soci´et´e G´en´erale Report, p. 5.
Financial Risk Outlook 2006, p. 42. Structured Capital at Risk Products represented only
a small part of the UK investment product market in 2007–8 (20,000 of the 844,000
investment products sold); nonetheless, this represented a 60 per cent increase on 2006–7:
FSA, Retail Investments Product Sales Data Trends Report September 2008 (2008), p. 8.
Lower levels of investment reflect greater investor familiarity with equity risk and a strong
bias towards packaged products: S. Johnson, ‘UK Takes Shine to Structured Products’,
Financial Times, Fund Management Supplement, 26 May 2008, p. 3.
Deutsche Bank, Retail Certificates: A German Success Story (Deutsche Bank Research, EU
Monitor 43, 2007), pp. 2–3; and BaFIN, Annual Report 2006, p. 27.
BME Report, p. 60.
A.-S. Rang Rasmussen, ‘Index-Linked Bonds’ in Danish Central Bank Monetary Review,
Second Quarter 2007 (Danish Central Bank, 2007), p. 51.
KPMG, The State of the Investment Management Industry, p. 23.
E.g. FSA, Financial Risk Outlook 2007, p. 55; and AFM, Exploratory Analysis, p. 12.
Soci´et´e G´en´erale Report, p. 7; and BME Report, p. 60.
FSA, Financial Risk Outlook 2005, p. 40. 341 AFM, Exploratory Analysis, p. 12.
structured and substitute products
183
regulatory regimes.342 But the empowerment attractions of these products
must be carefully balanced with the risks to vulnerable trusting investors.
From a design perspective, structured products are complex343 and often
opaque. Investor competence risks are accordingly heightened344 and disclosure risks become severe.345 Liquidity risks are considerable as the
secondary market for structured products tends to be illiquid.346 Difficult market conditions can cause product providers to withdraw from
market-making, increasing the potential investor losses.347 While advice
may take on some of the weight of investor protection, distribution
risks and mis-selling risks can be considerable.348 Retail investors are
also acutely vulnerable to products marketed as low-risk and capitalprotected and may not appreciate the impact of capital protection on
returns349 or that protection depends on the guarantee’s resilience.350
Although capital-protected products should have provided protection
against the ‘credit crunch’ market convulsions, they are only as strong
as the guarantor(s). The 2008 Lehman insolvency saw the first largescale stress on capital-protected structured products as Lehman-provided
capital protection failed for derivatives-based products.351 All these risks
are heightened as retail investor appetite for structured, and particularly capital-protected, products is increasing, particularly in the UK,352
342
343
344
345
347
349
351
352
As is the case in Germany where the regulatory regime has been linked to the success of
certificates.
Although equity-based products are most popular, some European products have been
based on CDOs, exposing investors to the risks of poor understanding of the implications
of different tranches: Credit Risk.
These risks were highlighted during the credit crunch by the impact of the Lehman collapse
on capital-protected products (K. Burgess and A. Ross, ‘L&G Will Pay Price of Lehman
Collapse’, Financial Times, 16 December 2008, p. 17) and by the exposure of retail investors
to the Madoff hedge fund fraud through structured notes: J. Mackintosh, F. Guerrera and
H. Sender, ‘Leading Banks Lent Billions to Feeder Funds for Bets on Madoff’, Financial
Times, 19 December 2008, p. 1.
See further ch. 5. 346 Bethel and Ferrell, Policy Issues, p. 22.
EFAMA, Response to Call for Evidence, p. 5. 348 See further ch. 4.
FSA, Financial Risk Outlook 2005, p. 46. 350 FSA, Financial Risk Outlook 2009, p. 64.
More than 2,000 investors in two Legal & General capital-protected funds which were
exposed to Lehman were warned of capital losses in December 2008: Burgess and Ross,
‘L&G Will Pay Price’. Complaints have also been made to the Financial Ombudsman
Service with respect to the sale and marketing of Lehman-guaranteed products (which
represented only £101 million of the total structured product market (£35 billion)) and
the FSA has a launched a wider review of structured product marketing and sales: Hughes,
‘Products’.
Drawing on industry data, the FSA has reported ‘significant pick-up’ in structured product
sales in the UK, particularly of products with capital protection, with a 25 per cent
increase in sales in 2008 from 2007, contrasting with downward trends in the sale of other
184
product regulation
in response to recent extreme market volatility353 and historically low
interest rates and as advisers rely more heavily on these products.354 But
most serious, perhaps, are the regulatory risks; structured products, which
reflect the ability of the market to exploit different forms of regulation,355
are vulnerable to considerable regulatory arbitrage risks, as discussed in
the following section.
2. A segmented product regime and its risks
a) Sectoral regulation
Depending on the complexity of the investment, investors in insurance-,
deposit- and investment-related substitutable products, including structured products, are exposed to similar risks concerning product design
but also with respect to disclosure and distribution.356 But these sectors
have traditionally been subject to discrete, silo-based regulation357 which
does not respond easily to substitute product risk. This has led to an international policy concern,358 well reflected in the wide-ranging 2008 report
by the Joint Forum359 and in the 2008 US Treasury Blueprint for reform
of the US regulatory and supervisory regime,360 as to the effectiveness of
sectoral regulation.
353
354
355
356
357
358
359
360
investment products and balancing outflows from retail CISs: D. Waters, FSA, Speech on
‘Industry Response to Developments in Regulation of Structured Products’, 12 February
2009, available via www.fsa.gov.uk/Pages/Library/index.shtml.
EFAMA reported a shift in demand from UCITS to structured products (and deposits)
over the worst of the market turbulence: Quarterly Statistical Release No. 36, p. 2.
Forty per cent of advisers canvassed by a Morgan Stanley survey in 2008 were more
likely to suggest structured products in volatile market conditions: Waters, ‘Industry
Response’.
S. Claessens, Current Challenges in Financial Regulation (2006), ssrn abstractid=953571.
For a review in the Canadian context, see A. Fok Kam, Implications for the Investment
Wrapper, Research Report prepared for the Task Force to Modernize Securities Legislation
in Canada: Evolving Investor Protection (2006).
Silo-based regulation was, for example, implicated in the UK 1990s pension mis-selling
scandal: J. Black and R. Nobles, ‘Personal Pensions Misselling: The Cases and Lessons of
Regulatory Failure’ (1998) 61 Modern Law Review 789. For a critique of the multi-sectored
approach to the US financial services industry, see Jackson, ‘Regulation’.
E.g. Fok Kam, Implications (in the Canadian market); and SFC, Investors Lack Understanding of Structured Products (2006) (in the Singapore market).
Joint Forum Report.
The US Treasury Blueprint’s call for an integrated supervisory structure was based, in part,
on the cross-sectoral nature of financial products: Department of Treasury, Blueprint for
a Modernized Financial Regulatory Structure (2008).
structured and substitute products
185
Under the silo-based EC regime, different regulatory regimes and varying levels of protection apply according to whether a product is insurancebased, a UCITS, deposit-based or a MiFID-scope investment product; the
current EC regime ‘does not form a homogeneous framework of rules
aimed at advising and protecting retail investors’.361 This segmentation
reflects the origins of the regime at a time when products were segmented
for regulatory purposes according to their different insurance (insurance),
savings (deposits) and investment (UCITS) functions and profiles, were
often subject to different tax treatment, and were distributed through different channels.362 Some tantalizing evidence of an earlier, if ambitious,
commitment to a horizontal approach is contained in the 1985 Internal
Market White Paper which saw the Commission call for a mutual recognition regime which would support the cross-border ‘exchange’ of ‘financial
products’, including UCITS.363
Regulatory untidiness in itself is not problematic, particularly where
local rules fill the gaps, although they do not always do so.364 But the
risk of investor and firm confusion as to the relevant protections arises.365
Most seriously, particularly where sectoral regulation is uneven, regulatory
arbitrage risks are generated.366 Regulatory arbitrage is a long-established
feature of sectoral regulation and is a rational response to regulation.367
But it is significant in the EC regime, as has been highlighted by FINUSE368 and the Delmas Report; the Report highlighted the example of
a French product provider who was able to avoid AMF oversight of its
complex and high-risk investment product by repackaging a UCITS product as a functionally identical structured product within a unit-linked
insurance product issue which was listed by a subsidiary in another
361
363
364
365
366
367
368
Need for a Coherent Approach, p. 9. 362 Ibid., pp. 3 and 8.
European Commission, Completing the Internal Market (COM (85) 310), para. 102.
Structured deposits, for example, are, for the most part, not treated as investments (with
some exceptions, including marketing requirements) under the UK FSMA regime reflecting, in part, the prudential regulation of banks, although the regime is under review and
banking conduct-of-business regulation is being reformed: for example, Waters, ‘Industry
Response’.
HM Treasury, Notification and Justification for Retention of the FSA’s Requirements on the
Use of Dealing Commissions under Article 4 of Directive 2006/73/EC Implementing Directive
2004/39/EC and Notification and Justification for Retention of Certain Requirements Relating
to the Market for Packaged Products under Article 4 of Directive 2006/73/EC Implementing
Directive 2004/39/EC (2007) (‘UK Article 4 Application’), p. 11.
Joint Forum Report, p. 6.
Jackson, ‘Regulation’. Arbitrage risks were one of the drivers for the proposed new US
Consumer Financial Protection Agency.
E.g. FIN-USE, Response to Expert Group on Market Efficiency (2006).
186
product regulation
Member State.369 Retail investors already face formidable difficulties in
exercising informed choice and driving the production of appropriate
products. These are exacerbated by regulatory arbitrage which leads to
products being designed to avoid regulation rather than in response to
investor needs.
b) Product regulation and substitute products
The regulatory arbitrage and investor protection risks posed by the segmented distribution and disclosure regime for different investment products are discussed in chapters 4 and 5. But these fragmented product design
regime is also problematic.
Unlike UCITS, unit-linked insurance products are not subject to specific liquidity and diversification requirements. Under the harmonized life
insurance regime, insurance company authorization is given to an insurance company for unit-linked insurance as a class.370 Structured securities are subject only to the issuer’s obligation to produce an authorized
prospectus under the prospectus regime.371 Structured deposits are not
subject to any harmonized product requirements. Regulatory arbitrage
risks are increased by the more cumbersome authorization procedures
which apply to UCITS and the longer ‘time to market’ of the UCITS
product.
The high-level requirements of the EC’s admission regime do not
provide back-stop product design protections with respect to listed
products.372 The principles-based admission-to-trading regime which
applies under MiFID and the MiFID Level 2 Regulation373 is designed
to support fair, orderly and efficient trading. It focuses on the availability
369
370
371
372
373
Delmas Report, p. 17.
Directive 2002/83/EC of the European Parliament and Council of 5 November 2002
concerning life assurance, OJ 2002 No. L345/1. The related investments are, however,
limited to specified financial assets. The insurance regime is being significantly reformed
and recast under the wide-ranging Solvency II reforms (based on COM (2008) 119), due
to be adopted by summer 2009 and implemented by 2012, which will consolidate but also
reform the different insurance measures, including the life assurance regime, notably by
the adoption of a risk-based approach to solvency requirements.
Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003
on the prospectus to be published when securities are offered to the public or admitted to
trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64. See further ch. 4.
Listing accounts for only approximately 4 per cent of overall non-UCITS scheme sales to
individual investors; listed real estate funds represent about 50 per cent of the total: 2008
PwC Retailization Report, p. 12.
MiFID Level 2 Regulation (OJ 2006 No. L241/1), Arts. 35 (transferable securities and
shares) and 36 (CISs).
structured and substitute products
187
of disclosure, the extent of the security’s distribution and, particularly for
CISs, compliance with marketing preconditions in the relevant regulated
market’s jurisdiction, redemption arrangements and the transparency of
unit valuation. Although the admission requirements are designed to support investor protection, they impose only minimal requirements and
are designed to allow regulated markets to develop their own admission
regimes and market segments, as the London Stock Exchange has done.374
They do not engage with product design.
3. Developing a response
Domestic regimes are already grappling with substitute product risks. But,
reflecting the expanding reach of EC retail market policy, the Commission, following an ECOFIN request in May 2007, has seized the agenda,375
publishing an initial Call for Evidence on substitute products in November 2007.376 Institutional concern has also come from the 3L3 committees, which are independently considering substitute product risks,377 the
Council378 and the European Parliament.379
From the outset, there appeared to be some support from the retail
and supervisory sectors for a degree of harmonization.380 But the risks
of a massive re-engineering of the EC design, distribution and disclosure
regime to apply to a notional class of investment products, which would
not reflect international practice,381 are considerable. A key threshold
374
375
376
377
378
379
380
381
The London Stock Exchange’s Specialist Fund Market is a regulated market subject to
MiFID’s admission requirements and supports the trading of specialized schemes including closed-end private equity funds, hedge funds, sovereign wealth funds and specialist
property funds.
E.g. European Commission, Staff Working Paper, p. 5; and European Commission, Green
Paper on Retail Financial Services in the Single Market (COM (2007) 226), p. 17.
Need for a Coherent Approach.
CESR, 3L3 Medium Term Work Programme: Consultation Paper (CESR/07-775, 2007),
pp. 11–12.
ECOFIN Council Conclusions, 2798th ECOFIN Meeting, 8 May 2007, Press Release,
p. 11. The Council’s Financial Services Committee also suggested that the advice and sales
regime be considered to ensure that investors were not disadvantaged by particular sales
channels or products: FSC Report, p. 36.
Klinz II Resolution. The Parliament called for a review of the legislative framework for
marketing, advice and sales for all retail investment products to ensure a coherent approach
to investor protection.
European Commission, Feedback Statement on Contributions to the Call for Evidence on
Substitute Retail Investment Products (2008), pp. 29–30.
The Joint Forum simply suggested that countries have consistent, or similar, disclosure
and suitability standards: Joint Forum Report, p. 52.
188
product regulation
question concerns whether the risks of regulatory arbitrage and of gaps in
the harmonized regime (particularly with respect to structured products)
are outweighed by the costs of intervention. Risk appetites for different
products vary considerably across the Member States; products are often
designed for local market investment needs. The cross-border market in
investment products is limited, as is clear from the UCITS regime,382 and
cross-border distribution structures are only developing. Local regulators
may therefore be best placed to address any gaps which arise in the harmonized regime;383 the FSA’s packaged product regime, for example, is
designed to address the risks of segmented regulation, and the FSA has
not appeared supportive of harmonization.384 A harmonization strategy
might provide a focal point for industry lobbying efforts which, given that
battle-lines for competitive advantage are being drawn,385 might increase
the risks of poor regulatory design. Substitute products are an elusive
class to define; whether or not investment products are in practice substitutable can be unclear.386 Intervention is likely to be poorly designed
without considerably greater evidence on MiFID’s effectiveness, particularly with respect to product disclosure and distribution risks. Ill-judged
and costly harmonization could stifle investors’ opportunities for higher
382
383
384
385
386
Pan-EC cross-border activity is low, with less than one-fifth of all UCITS in the form of
cross-border schemes in that they are sold in more than one Member State outside the
Member State of registration: Investment Funds Green Paper, p. 12.
The UK FSA is supportive of domestic solutions given divergences in investor preferences
and distribution structures and limited cross-border activity: FSA, Response to the European
Commission’s Call for Evidence on Need for a Coherent Approach to Product Transparency
and Distribution Requirements for ‘Substitute’ Retail Investment Products (2008) (‘FSA
Substitute Products Response’), p. 1.
See further ch. 1. The FSA has highlighted that two major recent mis-selling scandals
(concerning personal pensions and endowment policies used to repay mortgage debt)
concerned products outside MiFID’s scope but which were addressed through the FSA’s
packaged products regime and its horizontal approach to distribution and disclosure risks:
UK Article 4 Application.
The Commission’s 2008 Industry Workshop, for example, saw battle-lines drawn, with the
European Derivatives Association resisting a roll-out of the UCITS disclosure regime and
EFAMA calling for a level playing field: European Commission, Minutes of the Industry
Workshop on Retail Investment Products (2008), pp. 3–4.
The European Banking Federation, for example, has argued that UCITS operate under
a collective mandate and expose investors to the risks of investment management while
structured products offer a return linked to the product’s design: European Banking
Federation, Response to Call for Evidence (2008), pp. 1 and 3. The European Derivatives
Association has similarly argued that structured products represent a contractual obligation while CIS management involves a fiduciary obligation to act in the best interests of
investors: Commission, Minutes of Industry Workshop, p. 3.
structured and substitute products
189
returns and better diversification. Market solutions are developing,387 perhaps in response to the threat of intervention implicit in the EC policy
debate.
But regulatory (and supervisory) arbitrage between different sectoral
regimes remains a risk both locally, where Member States do not ‘fill the
gaps’ through local rules, and on a pan-EC basis. It is particularly acute on a
pan-EC basis as regulators’ incentives vary; the UCITS experience suggests
that Member States who are net UCITS exporters are likely to take a more
relaxed approach to regulation and supervision than those with significant
local markets.388 The retail market is also somewhat fragile. Widespread
mis-selling could damage confidence in more tightly regulated products
and in long-term saving. It is not efficient that the massive regulatory and
industry resources expended on the UCITS product can be so easily wasted
where the UCITS is wrapped in another product or where a UCITS-style
product is constructed as a unit-linked insurance product or structured
security. Neither is it efficient that MiFID’s distribution regime can be
side-stepped by designing a product as an ex-MiFID deposit- or insurancebased product. The risks of harmonization may also be mitigated by what
appears to be a measured approach to potential reforms. A wide range
of stakeholders have been engaged in an extensive consultation process389
(although retail engagement remains troublesome390 ). The Commission’s
Call for Evidence was carefully couched in terms of whether intervention
across the market was desirable; Commissioner McCreevy warned that
‘throwing European rules at the problem will not make it go away’ and
that such a major undertaking called for care and an evidence-based
approach.391
The UCITS experience suggests that further product design and
labelling efforts, even in an attempt to address particular risks (such as
387
388
389
390
391
Joint Associations Committee (representing a group of trade associations), Retail Structured Products: Principles for Managing the Distributor–Individual Investor Relationship
(2008).
European Commission, Simplified Prospectus Workshops 15 May 2006 and 11 July 2006:
Issues Paper (2006), pp. 10–11.
The 2007 Call for Evidence was followed by a Feedback Document, a 2008 Industry
Workshop and a 2008 Open Hearing.
See further ch. 7. FIN-USE has, however, been engaged from the outset and has called for
harmonized high-level principles on conflicts of interests, training and competence, and
disclosure.
Closing Address, Public Commission Hearing on Retail Financial Services, 19 September
2007, available via http://europa.eu/rapid/searchAction.do.
190
product regulation
the liquidity risks of structured products), are ill-advised and wasteful
of regulatory resources. The removal of regulatory arbitrage possibilities
with respect to disclosure and distribution may have the indirect effect of
limiting the proliferation of complex and subtly differentiated products
and thereby improve product design. But, in the absence of more radical
‘law in action’ reforms on the lines of the FSA’s ‘product life cycle’ model,
there is little that harmonized regulation can do to drive better product
design. Investor discipline may be strengthened by financial capability and
disclosure initiatives, but these are long-term strategies. Ultimately, the
risks of structured/substitute products must be carried by the horizontal
distribution and, to a lesser extent, disclosure regimes.
The Commission issued its first formal response to the substitute products question in April 2009 with its Packaged Products Communication.
The ambition of the proposed reform is striking and somewhat unexpected
given the ‘light-touch’ tenor of earlier policy discussions. The Commission has suggested that the current fragmented harmonized disclosure
and distribution/advice regimes be radically reconfigured such that new
horizontal disclosure and ‘selling’ regimes apply to ‘packaged products’
and that there is ‘a coherent basis for the regulation of mandatory disclosures and selling practices at European level, irrespective of how the
product is packaged or sold’.392 It appears that radical reforms to MiFID
are therefore envisaged, despite the massive resources already expended
on its negotiation and implementation, although the Commission has
acknowledged that MiFID’s conduct-of-business and conflict-of-interest
rules could act as a benchmark. The reform is designed to address the
risks of investor detriment, remove regulatory arbitrage risk and minimize divergent national approaches. A sweeping reform of this nature
would certainly address regulatory arbitrage risk and it is heartening that
product design reforms are not being canvassed.393 More advanced regulatory technology could also be applied; CESR has become considerably
more experienced with retail market risks and their management since the
MiFID negotiation period.
But the challenges are very considerable. Great care will be needed
in defining the ‘packaged products’ which will define the scope of the
392
393
Packaged Products Communication, p. 2.
The Commission noted that product design strategies were difficult to implement effectively given financial innovation (ibid., p. 5), while the related impact assessment noted
that the ‘practical challenges . . . would be immense and net market outcomes deleterious’
(p. 10).
structured and substitute products
191
regime.394 The scale of the new regime, and the related scope for error,
looks to be significant; the Commission has suggested that core principles could be adopted for all products (presumably at level 1) but that
detailed rules, adapted to specific products, could also be adopted (presumably at level 2).395 It appears that the existing sectoral legislation will
be repealed;396 unintended effects and regulatory error could therefore
be considerable. Industry costs in adapting to a new regime are likely to
be significant, however similar that regime may be, in terms of selling
requirements, to MiFID. Any roll-out of a new disclosure regime will also
impose immense demands on the industry as detailed harmonization has
thus far been limited to UCITS. Local innovation and flexibility may be
prejudiced; the Commission appears to be in search of much greater regulatory tidiness, warning of the lack of coherence in the current framework,
acknowledging local regulatory and market efforts but warning of the
limited geographical scope of local reform efforts and of barriers to the
single market, highlighting that gold-plating restrictions may inhibit local
efforts and calling for a systematic and co-ordinated approach.397 It also
may not be unreasonable to imply some Commission empire-building
dynamics. Certainly, some investor detriment is likely to be associated
with the current fragmented regime, particularly given the popularity of
unit-linked insurance products which fall outside MiFID, but the impact
assessment is not entirely convincing, focusing for the most part on expert
opinion and highlighting the patchwork nature of the current regime but
presenting little empirical evidence of market failure.398 The risks of this
proposed massive redesign are very considerable unless great care is taken.
But, if nothing else, it points to the scale of the Commission’s ambitions
in the retail markets.
394
395
398
The Commission seems to envisage that CISs, unit-linked products and structured deposits
would be included as packaged products and, more vaguely, has suggested that packaged
products offer exposure to underlying assets, are designed to support capital accumulation,
have the mid-to-long-term market in mind and are marketed directly to retail investors:
Packaged Products Communication, p. 3.
Ibid., p. 9. 396 Ibid., p. 11. 397 Ibid., pp. 6 and 8.
To the contrary, it acknowledged that the risks of investor detriment were difficult to
quantify, that there was little systematic empirical evidence on disclosure failures, that
there was no strong evidence of the extent to which inconsistencies and gaps in the selling
regime might have led to investor detriment or competitive distortions and that there was
limited practical experience with the MiFID regime: Packaged Products Impact Assessment,
pp. 13 and 16–17.
4
Investment advice and product distribution
I. Intermediation, its risks and regulation
1. The benefits of advice
The EC retail market is strongly characterized by intermediation in the
form of investment advice and related investment product distribution
services.1 Reliance on advisers, whether in the form of independent advisers or, more commonly, bank-based financial supermarkets, is significant.2
This reliance is in many respects inevitable and rational, and it can lead
to stronger market engagement. Investment advice has an educational
dimension.3 The adviser can counter decision-making defects4 and dilute
deeply rooted biases, including framing effects,5 the status quo effect, the
tendency to sell winners more quickly than losers6 and the home bias,
which can drive poor diversification.7 Given that information-gathering
represents a significant barrier to retail market entry, advice may improve
market engagement in that information-gathering is outsourced to the
1
2
3
4
5
6
7
The relationship between ‘advice’ and product distribution and sales is explored in sect. X
below.
See further ch. 2.
FIN-USE, Financial Education: Changing to Second Gear (2008), p. 8.
E.g. G. La Blanc and J. Rachlinski, In Praise of Investor Irrationality (2005), ssrn
abstractid=700170, p. 22; J. Rachlinski, ‘The Uncertain Psychological Case for Paternalism’ (2003) 97 Northwestern University Law Review 1165; and J. Arlen, ‘Comment: The
Future of Behavioral Economic Analysis of Law’ (1998) 52 Vanderbilt Law Review 1765.
J. Drukman, ‘Using Credible Advice to Overcome Framing Effects’ (2001) 17 Journal of Law,
Economics, and Organization 62.
Z. Shapira and I. Venezia, ‘Patterns of Behavior of Professionally Managed and Independent
Investors’ (2001) 25 Journal of Banking and Finance 1573.
A. Palmiter and A. Taha, Mutual Fund Investors: Divergent Profiles (2008), ssrn
abstractid=1098991; and Shapira and Venezia, ‘Patterns’. The BME Report predicted that
better informed advisers would increasingly offer the most competitive products to investors,
regardless of the products’ country of origin: BME Consulting, The EU Market for Consumer
Long-Term Retail Savings Vehicles: Comparative Analysis of Products, Market Structure, Costs,
Distribution Systems and Consumer Savings Patterns (2007) (‘BME Report’), p. 215.
192
intermediation, its risks and regulation
193
adviser.8 Market risks may be contained where advice is sought and higher
returns may follow;9 evidence from Germany10 and the UK11 suggests
positive outcomes from advice.
2. The risks
But investors face a series of risks from advice services. The relationship
between the service provider and the investor is characterized by often
severe informational asymmetries and by limited investor competence.
Retail investors are rarely in a position to monitor advisers effectively12
and have difficulties in assessing the quality of advice.13 Decision-making
difficulties are exacerbated as adviser failures may not become apparent
for some time14 and as retail investors are unlikely to gain experience as
investment decisions tend to be irregular.15 Over-reliance on and excessive
trust in advisers is likely,16 particularly by older investors seeking to change
8
9
10
11
12
13
14
15
16
P. Shum and M. Faig, ‘What Explains Household Stock Holdings’ (2006) 30 Journal of
Banking and Finance 2579 (the study, based on US household investment, is inconclusive,
given the range of variables which affect market participation).
Professionally managed accounts have been shown to display better performance: Shapira
and Venezia ‘Patterns’. A link has also been made between positive future returns and
trades through full-service brokers: B. Barber and T. Odean, ‘Trading is Hazardous to Your
Wealth: The Common Stock Investment Performance of Individual Investors’ (2000) 55
Journal of Finance 773.
R. Bluethgen, A. Gintschel, A. Hackethal and A. Mueller, Financial Advice and Individual
Investors’ Portfolios (2008), ssrn abstractid=968197.
Financial Services Authority (‘FSA’), Stopping Short: Why Do So Many Consumers Stop
Contributing to Long-Term Savings Policies (Occasional Paper No. 21, 2004), p. 6 (finding
longer persistence where products are sold by advisers rather than agents).
H. Jackson, ‘Regulation in a Multisectored Financial Services Industry: An Exploration
Essay’ (1999) 77 Washington University Law Quarterly 319; and, for a stakeholder perspective, FIN-USE, Financial Services, Consumers and Small Businesses: A User Perspective
on the Reports on Banking, Asset Management, Securities, and Insurance, of the Post FSAP
Stocktaking Groups (2004), p. 10.
The Australian regulator (ASIC) has found that 85 per cent of retail investors were happy
with advice which it regarded as non-compliant with quality standards: ASIC, Shadow
Shopping on Superannuation Advice: ASIC Surveillance Report (2006), p. 22. UK and EC
investors appear to be similarly trusting: n. 16 below.
Oxera, Assessment of the Benefits of the Suitability Letter: A Report Prepared for the FSA
(2007), p. 4.
The Sandler Report, Medium and Long-Term Retail Savings in the UK: A Review (2002)
(‘Sandler Report’), p. 4.
Only 10 per cent of EC consumers surveyed sought information independently when
they took advice: BME Report, p. 194. It also reported generally high levels of trust in
intermediaries (p. 197). The FSA has found that 92 per cent of those receiving financial
advice were confident as to the appropriateness of the advice (Consumer Awareness of the
194
investment advice and product distribution
the composition of their portfolios and who face very considerable risks
from poor-quality advice.17
Imperfect information, weak monitoring, poor decision-making and
excessive trust can expose investors to a series of risks from the principal/agent relationship which characterizes the service provider/investor
relationship18 and from the related incentive misalignment risk.19 These
include fraud, misuse of investor funds, conflicts of interests, poor-quality
advice/mis-selling and incompetence;20 although there is some evidence of
advisers improving investment performance, this is not always the case.21
Many of these failures reflect behavioural weaknesses on the part of the
adviser which may simply replace, and not displace, those of the investor.22
The risks of intermediation are exacerbated in the integrated market as
domestic supervision of cross-border advisers may not be robust (chapter
8) and locally tailored regulation may be threatened by harmonization
requirements.
17
18
19
20
21
22
FSA and Financial Regulation (Consumer Research No. 67, 2008), p. 36) and that investors
regard the possibility of serious loss as remote, in part because of a belief that advisers would
not recommend a risky product: FSA, Consumer Research No. 5, Informed Decisions? How
Consumers Use Key Features: A Synthesis of Research in the Use of Product Information at the
Point of Sale (Consumer Research No. 5, 2000), p. 18.
SEC, North American Securities Administrators Association, and FINRA, Protecting Senior
Investors: Compliance, Supervisory and Other Practices Used by Financial Services Firms in
Serving Senior Investors (2008) (‘Senior Investors’).
S. Choi, ‘A Framework for the Regulation of Securities Market Intermediaries’ (2004) 1
Berkeley Business Law Journal 45.
M. Condon, ‘Rethinking Enforcement and Litigation in Ontario Securities Regulation’
(2006) 32 Queen’s Law Journal 1.
T. Odean, ‘Are Investors Reluctant to Realise Their Losses?’ (1998) 53 Journal of Finance
1775.
Palmiter and Taha, Mutual Fund Investors, pp. 50–4 (advisers can exercise poor judgment
and may be prone to over-reliance on past performance information); and D. Bergstresser,
J. Chalmers and P. Tufano, ‘Assessing the Costs and Benefits of Brokers in the Mutual Fund
Industry’ (2007), ssrn abstractid=616981 (finding, with respect to CIS sales, that brokers
did not provide superior market timing ability, sales were directed towards schemes with
higher distribution fees and brokers appeared to chase returns). Similar findings were made
in an FSA-commissioned study (CRA International, Benefits of Regulation: Effect of Charges
Table and Reduction in Yield (2008)), which found that intermediaries rely more heavily
on past performance information (60 per cent) than on charges disclosure (25 per cent):
p. 19. The pan-EC Optem Report on disclosure highlighted that, notwithstanding high
levels of reliance on advisers, there was concern that advisers were not competent, did not
make efforts to educate investors, were salespersons rather than advisers and had limited
commitment to the investor: Optem, Pre-contractual Information for Financial Services:
Qualitative Study in the 27 Member States (2008) (‘Optem Report’), p. 96.
La Blanc and Rachlinski, In Praise; and D. Langevoort, ‘Selling Hope, Selling Risk: Some
Lessons from Behavioral Economics about Stockbrokers and Sophisticated Investors’
(1996) 84 California Law Review 627.
intermediation, its risks and regulation
195
Conflicts-of-interest and mis-selling risks are particularly acute. Intermediation must be paid for and the scale of intermediation in the EC
means that commission payments from product sales or advice, discussed
in section X below, pose significant risks to the quality and objectivity of
investment advice. But incentive misalignment is not simply a function of
commission risk; it is also a function of regulatory risk. Capital requirements and the relative costs of product production can distort advisers’
and distributors’ incentives. The new Solvency II regime for insurance
companies has been associated with the risk of unit-linked insurance
products, which are often complex and opaque but which are burgeoning
in the EC market, being pressed on insurance customers as these products are subject to a lower capital charge under the solvency regime.23 A
similar dynamic can lead to advisers and distributors promoting products, such as unit-linked products and deposit-based products, which fall
outside MiFID’s requirements and, in particular, its commission disclosure requirements.24 Crisis conditions also exacerbate conflict-of-interest
risks. Over the ‘credit crunch’, banks, under pressure to repair their balance sheets, were reported to be promoting deposit-based products more
heavily than CIS investments.25 Retail investors, displaying high risk aversion in the short term, may also be exposed to increased mis-selling risk,26
particularly with respect to costly capital-protected products. The risks are
all the greater as investment advisers are largely concerned with shaping
demand, and with promoting willingness to take on risk.27 Technological advances also mean that investors may face conflict-of-interest and
other risks where advice is provided online or through platforms and
wraps (online services which are growing in popularity in the UK and
continental Europe28 and which are used by advisers to view and administer investment portfolios and to buy and sell investment products).29
23
24
25
26
27
29
As highlighted in FIN-USE, Solvency II Regime – Principles to Ensure End-User Protection
(2009), p. 4. The Solvency II regime (based on COM (2008) 119) was due to be adopted
by summer 2009 and to be implemented by 2012.
Sect. IX below.
P. Skypala, ‘ETFs the Only Bright Spot as Outflows Roll on’, Financial Times, 24 November
2008, p. 15, noting banks’ attempts to repair their balance sheets and steer customers from
bond funds into deposits; and S. Johnson, ‘UCITS Outflows Soar in Q3’, Financial Times,
Fund Management Supplement, 1 December 2008, p. 2, reporting higher levels of switching
from CISs to deposits in southern Europe. The European Fund and Asset Management
Association (EFAMA) also reported an outflow from UCITS to deposits (and structured
products): EFAMA, Quarterly Statistical Release No. 36 (2008).
FSA, Financial Risk Outlook 2009, pp. 39–40 and 64.
Langevoort, ‘Selling Hope’, 649. 28 BME Report, p. 172.
FSA, Platforms: The Role of Wraps and Fund Supermarkets (Discussion Paper No. 07/2,
2007), pp. 3 and 7.
196
investment advice and product distribution
Although they can enhance the quality of advice, wraps and platforms
also pose risks where suitability requirements are not met in the selection
of the wrap or platform and where conflicts of interest arise where firms
hold financial interests in wraps and platforms.
3. Regulating advice
As suggested in chapter 2, an effective retail market policy must include
imaginative supply-side rules ‘in action’ if it is to reflect appropriately
retail investor vulnerabilities while supporting engagement. These rules
must focus on the pivotal advice and related product distribution process. Notwithstanding the advantages of advice, the extent of investor
reliance, particularly by trusting investors but also by more empowered
investors who are faced with increasingly complex choices, coupled with
poor investor monitoring, suggests that regulation is necessary. So too do
the risks posed by the advice process and the corresponding need to ensure
that the ability of the advice industry to strengthen market engagement is
not compromised.30
More positively, investment advice and its regulation provide the
strongest line of defence for investors31 who are faced with a proliferating, substitutable and complex range of products and with voluminous
regulated and other disclosures. Disclosure is a severely limited tool. Product regulation has failed to control the proliferation of a vast range of often
highly complex products and is a weak investor protection mechanism.32
Segmentation strategies can struggle in shielding investors from the riskiest and most complex of products and in, at the same time, ensuring that
30
31
32
The Delmas Report warned of the danger that mis-selling could dissuade savers from the
markets, generate reputation and litigation risks for firms and risk damage to the financial
system as a whole (J. Delmas-Marsalet, Report on the Marketing of Financial Products for the
French Government (2005) (‘Delmas Report’), p. 12), while the Joint Forum has highlighted
the risks mis-selling poses to firm solvency, reputational risk and innovation (Basel Committee on Banking Supervision, International Organization of Securities Commissions,
International Association of Insurance Supervisors, Customer Suitability in the Retail Sale
of Financial Products and Services (Bank for International Settlements, 2008) (‘Joint Forum
Report’), p. 6).
The International Swaps and Derivatives Association (ISDA), in the context of the substitute
products debate, has suggested that the ‘best investor protection model would be that of
independent advice’: European Commission, Minutes of the Industry Workshop on Retail
Investment Products (2008), p. 4.
E.g. Joint Associations Committee (representing a group of leading financial market trade
associations), Response to Commission Call for Evidence on Substitute Products 2008, calling
for a distribution/suitability-based approach rather than one based on product regulation
(p. 2). See ch. 3.
intermediation, its risks and regulation
197
retail investors benefit from innovation, particularly with respect to the
management of market risk. The advice process, however, can filter disclosure and products. Horizontal advice and distribution strategies can also
deliver stronger protection against market risk. This can take the form of
high-quality diversification advice. But the regulation of advice can also
support the sale of riskier products33 which may manage market risks more
effectively.34 Where investment advice fails, however, the risks to investors
can be acute given limited product regulation and the inadequacies of
disclosure regulation.35
The concern to promote engagement, increased recourse to advice36
and the risks of the advice process have led to an international regulatory focus on distribution and advice and, in particular, on the quality
of advice.37 Internationally, the 2008 Joint Forum Report placed the sale
of financial products and services ‘at the core of consumer confidence in
financial markets’.38 Earlier, and following the recommendations of the
1997 Wallis Committee,39 large-scale reform to the delivery of investment advice was adopted in Australia under the Financial Services Reform
2001.40 Following a spate of scandals,41 mis-selling risks in the advice and
sales process and the consequent risks to household financial planning,
have become a regulatory preoccupation in the Community42 and of the
33
34
35
36
37
38
39
40
41
42
J. Benjamin, Financial Law (Oxford: Oxford University Press, 2007), p. 252.
In the UK, non-regulated CISs may be recommended to investors in the course of an advice
relationship and where suitability requirements are met: COBS 4.12.
As is clear from the emerging concern in the UK market as to the potential mis-selling of
structured products in the wake of the Lehman collapse.
The European independent advice market is likely to grow as investments become more
complex and as the need for market savings becomes more acute: Oxera, Description and
Assessment of the National Compensation Schemes Established in Accordance with Directive
97/9: A Report for the Commission (2005), p. 106; and Subgroup (of the Council of the
EU’s Financial Services Committee) on the Implications of Ageing on Financial Markets,
Interim Report to the FSC (FSC4180/06, 2006) (‘FSC Report’).
The 2008 US Treasury ‘blueprint’ (Department of Treasury, Blueprint for a Modernized
Financial Regulatory Structure (2008)), for example, considered the differential treatment
in the US of investment advisers and broker-dealers.
Joint Forum Report, p. 4.
Wallis Committee, Final Report on the Financial System Inquiry (1997).
A subsequent series of reforms were adopted in 2005: Australian Treasury, Refinements to
Financial Services Regulation: Proposals Paper (2005).
‘[M]ost large countries in the development of their financial market economy have experienced in the recent past problems of misselling ranging from recourse to abusive marketing
practices to the sale of unsuitable products’: Delmas Report, p. 9.
‘[R]egulatory regimes which previously focused almost solely on prudential issues are
gradually putting an increasing focus on the quality of the sales process’: FSA, A Review of
Retail Distribution (Discussion Paper No. 07/1, 2007) (‘2007 RDR’), Annex 3, p. 12.
198
investment advice and product distribution
EC institutions,43 although in practice the 2007 BME Report suggests that
mis-selling is not a major concern for European households.44
The FSA has consistently highlighted the importance of an effective
investment advice and product distribution market given pressure on
household savings and the need for greater financial independence,45 and
acknowledged investor dependence on advice channels.46 The FSA’s experience of mis-selling47 was one of the drivers for its opening of the Retail
Distribution Review (RDR) in 2007 (sections XI and XII below),48 which
was designed to address ‘significant and persistent problems’ in the distribution of retail investment products and particularly commission risk.49
Advice was also the focus of the Thoresen Review, which recommended
the establishment of a ‘generic advice’ service, independent of the sales
process (chapter 7); the quality of advice is also a central pillar of the FSA’s
‘law in action’ Treating Customers Fairly (TCF) strategy.50
But the concern to address advice and product distribution risks crosses
different national advice and distribution patterns. The 2005 Delmas
43
44
45
46
47
48
49
50
The Council’s Financial Services Committee has warned that the pressure on households to
cover welfare needs previously carried by government, and the increased product selection
risk, required that appropriate advice mechanisms be in place to mitigate mis-selling risks:
FSC Report, p. 15.
The report found that ‘only’ 8.1 per cent of consumers had personal experience of misselling (although 20.8 per cent knew of someone who had experienced mis-selling): BME
Report, p. 197.
E.g. Financial Risk Outlook 2008, p. 46; Financial Risk Outlook 2007, p. 94; and Financial
Risk Outlook 2006, pp. 84–5. FSMA also requires the FSA to take into account consumers’
needs for advice and accurate information: sect. 5(2)(c). HM Treasury has highlighted the
importance of advice: HM Treasury, Financial Capability: The Government’s Long-Term
Approach (2007), p. 6.
‘[M]any people will continue to find financial services bewildering and will want some
customized help to identify their financial needs and so make better decisions’: FSA,
Building Financial Capability in the UK: The Role of Advice (2004), p. 1. The RDR, discussed
in sects. XI and XII below, is heavily based on meeting the needs for effective advice and
distribution: 2007 RDR, p. 17.
The FSA has warned that shortcomings persist in the way in which investment products
are sold and with respect to the quality of advice and highlighted that the reputation of
financial advisers and other distributors had suffered from mis-selling: FSA, Financial Risk
Outlook 2007, p. 10.
2007 RDR; Retail Distribution Review – Interim Report (2008) (‘2008 Interim RDR’); and
Retail Distribution Review: Feedback Statement No. 08/6 (2008) (‘2008 RDR Feedback Statement’). Concrete proposals were made in June 2009: Consultation Paper No. 09/18, 2009.
C. Briault, FSA, Speech on ‘Regulatory Developments and the Challenges Ahead’, 30 January
2008, available via www.fsa.gov.uk/Pages/Library/Communications/Speeches/index.shtml.
Which includes one of the largest research studies undertaken into the quality of advice:
FSA, Quality of Advice Process in Firms Offering Financial Advice: Findings of a Mystery
Shopping Exercise (Consumer Research No. 52, 2006).
intermediation, its risks and regulation
199
Report for the French AMF highlighted the increased need for clear,
fair and not misleading investment advice as increased pressure was
placed on households for long-term savings provision.51 It pointed to
repeated mis-selling episodes, notably with respect to structured fund
sales,52 and emphasized the importance of impartial, accurate and appropriate advice.53 The Netherlands has experienced particular difficulties in
the sale of unit-linked insurance products, related, in part, to commission risks, as well as with respect to sales of share lease agreements;54 the
Dutch market conduct regulator (the AFM) has isolated the quality of
advice as a priority issue and supported a shift from product-oriented to
investor-oriented services.55 The German BaFIN has also highlighted the
risks posed by commission sales,56 and has recently focused its supervisory
efforts on the advisory process, as has the Italian supervisor, CONSOB.57
Following an increase in demand for investment advice, Spain is also
focusing on advice and the role of regulation,58 while Sweden adopted a
new regime for financial advisers in 2004.59
Member States’ efforts occur, however, within an extensive harmonized
regulatory framework ‘on the books’, governed by MiFID. At bedrock,
MiFID reflects the dictates of market integration and the harmonization
necessary to support the investment firm passport. But it is also strongly
regulatory in orientation and adopts a generally protective approach which
implies support for the trusting investor and which gives priority to supplyside conduct rules, as discussed later in this chapter.
But the risks of regulation are considerable in the advice context.
The trusting investor and the risks of the advice process suggest that
regulation must reflect investor vulnerabilities and investor over-reliance
on advisers; but, as discussed in this chapter, it is very difficult to achieve
strong outcomes ‘in action’ through regulation. Retail market policy
with ambitions to build an engaged retail investor constituency must also
51
53
54
55
56
57
58
Delmas Report, p. 8. 52 Ibid., p. 10.
Ibid., p. 8. It called for: improvements in product information; better-targeted marketing;
appropriate, objective and impartial advice; and an improvement in after-sales service.
Summarized in AMF, Working Program for Domestic and International Regulation 2006–
2008 (2006), p. 19, which supported the proposed reforms.
Joint Forum Report, pp. 76 and 78.
AFM, Policy and Priorities for the 2007–2009 Period (2007), pp. 7 and 23.
BaFIN, Annual Report 2006, p. 27.
BaFIN, Annual Report 2006, p. 136 and Annual Report 2005, p. 131. CONSOB has targeted
sales networks, suitability assessments and conflict-of-interest requirements: CONSOB,
Annual Report 2006, p. 109.
Financial Services Consumer Group, Minutes, 3 July 2007, p. 4. 59 BME Report, p. 182.
200
investment advice and product distribution
grapple with more subtle problems. Investor engagement and empowerment call for measures which support the investor in identifying advice
needs, and in demanding, accessing and assessing appropriate services.
Access to advice is related to the sustainability of the advice sector;60 it
is therefore a function of solvency, liquidity and risk management, and
thus of prudential requirements (section XI below). It is also a function
of supervision and enforcement and of how the compensatory costs to
the industry of poor advice are managed.61 But access is also related
to whether the regulatory regime supports different advice channels of
varying cost which are sufficiently commercially viable. As discussed in
section XII below, the UK’s efforts in the retail advice and distribution
market have focused closely on access to advice and, although the design
difficulties faced by the FSA are formidable, the reforms represent a
paradigm shift from MiFID’s regulatory ‘on the books’ approach. Effective
regulation must also address the correct risks. As discussed further in
section X below, advice in the Community context is probably better
characterized in terms of product sales, or, at least, ‘advised sales’, rather
than in terms of full-scale, independent advice. But it is not clear that this
distinction is captured by the harmonized regulatory regime.
II. Scope of the advice and product distribution regime
1. The advice and distribution regime
MiFID and the MiFID Level 2 Directive,62 along with ancillary soft law
measures, including the Commission’s MiFID Q and A,63 CESR’s MiFID
60
61
62
63
The FSA has highlighted the viability of firms, given the financial crisis, as a risk to its retail
market objectives: FSA, Business Plan 2008–2009, p. 23; and FSA, Financial Risk Outlook
2008, p. 46.
The FSA has become concerned as to the costs of mis-selling in terms of the detriment
suffered by surviving firms: FSA, Review of the Prudential Rules for Personal Investment
Firms (Discussion Paper No. 07/4, 2007) and Review of the Prudential Rules for Personal
Investment Firms (Feedback Statement No. 08/2, 2008).
Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on
markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC
and Directive 2000/12/EC of the European Parliament and of the Council and repealing
Council Directive 93/22/EEC, OJ 2004 No. L145/1 (‘MiFID’); and Commission Directive
2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating conditions
for investment firms and defined terms for the purposes of that Directive, OJ 2006 No.
L241/26 (‘MiFID Level 2 Directive’).
‘Your Questions on MiFID’, available via http://ec.europa.eu/internal market/securities/
isd/questions/index en/.
scope of the advice and product distribution regime
201
Q and A64 and CESR’s level 3 guidance on MiFID,65 are at the heart of
the EC’s regulation of advice and of product distribution. The Insurance Mediation Directive66 applies to insurance agents and brokers67
and imposes minimum registration and professional competence requirements on agents and brokers,68 as well as disclosure, independence and
suitability-related standards on the sale of insurance products, including
unit-linked investment products which are outside MiFID’s scope.69 The
banking regime70 does not impose advice and distribution requirements
on non-MiFID banking products (such as structured deposits); while
MiFID applies to credit institutions, it does so only with respect to their
MiFID-scope investment services activities.71 MiFID applies, however,
to the management companies of UCITS, which are otherwise excluded
from the regime under Article 2(1)(h), where they provide, in addition
to collective portfolio management services, investment advice or discretionary portfolio management services. Marketing risks are addressed by a
matrix of consumer protection directives, chief among them the Distance
Marketing of Financial Services Directive72 and the Unfair Commercial
Practices Directive,73 as well as by MiFID. The contractual protections of
the horizontal Unfair Contract Terms Directive74 provide additional retail
64
65
66
67
68
69
70
71
72
73
74
CESR. Questions and Answers on MiFID: Common Positions Agreed by CESR Members
(December 2008 version) (CESR/08-943, 2008).
Including guidance on: the MiFID Passport (CESR/07-337 and CESR/07-337b); inducements (CESR/07-228b); best execution (CESR/07-320); record-keeping (CESR/06-552c);
passport notification (CESR/07-317); branch supervision (CESR/07-672); and transparency (CESR/07-043).
European Parliament and Council Directive 2002/92/EC of 9 December 2002 on insurance
mediation, 2003 OJ No. L9/3.
The Directive applies to insurance mediation but not to activities carried out by an insurance
undertaking or an employee of an insurance undertaking.
Arts. 3 and 4. Indemnity insurance requirements are also imposed (Art. 4(3)).
See sections IX below on the insurance regime.
Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006
relating to the taking up and pursuit of the business of credit institutions (recast), OJ 2006
No. L177/1.
MiFID, Art. 1(2).
European Parliament and Council Directive 2002/65/EC of 23 September 2002 concerning
the distance marketing of consumer financial services and amending Council Directive
90/619/EEC and Directives 97/7/EC and 98/27/EC, OJ 2002 No. L271/16 (‘Distance Marketing Directive’, or DMD).
Directive 2005/29/EC of the European Parliament and of the Council of 11 May 2005
concerning unfair business-to-consumer commercial practices in the internal market,
OJ 2005 No. L149/22 (‘Unfair Commercial Practices Directive’, or UCP).
Council Directive 93/13/EEC of 5 April 1993 on unfair terms in consumer contracts,
OJ 1993 No. L95/29.
202
investment advice and product distribution
investor protections. The segmented nature of the advice and distribution
regime, and, in particular, MiFID’s troublesome interaction with the distribution of UCITS units and of non-MiFID products, raises some doubts
as to its effectiveness in addressing real mass market risks and underlines
the difficulties in capturing advice and distribution risk in a segmented
regime.
2. MiFID’s scope: a wide range of instruments and services
MiFID applies to specified ‘investment services’ with respect to a wide
range of simple and complex ‘financial instruments’.75 These include structured products,76 which come within the scope of the ‘transferable securities’ which are included as financial instruments,77 and contracts for differences, bringing spread-betting in financial instruments within MiFID’s
protections. A wide range of derivatives, including commodity derivatives,
also come within MiFID’s scope. But MiFID does not cover unit-linked
insurance investments78 or deposit-based investments,79 which generates
significant regulatory arbitrage risks;80 Member States have the option,
of course, of extending MiFID distribution and advice requirements
across the universe of investment products (section IX below). Neither
does it cover decumulation, annuity products which are derived from
pension/life-assurance products and which pay a regular income.
The key MiFID-scope ‘services’81 from a retail investor perspective
include the reception and transmission of orders and order execution
75
76
77
78
79
80
81
The list (set out in MiFID Annex I, sect. C) includes: transferable securities; money market
instruments; units in collective investment undertakings; and financial derivatives in the
form of options, futures, swaps, forward rate agreements and any other derivative contracts
relating to securities, currencies, interest rates or yields, or other derivatives instruments,
financial indices or financial measures which may be settled physically or in cash.
J.-P. Casey, Shedding Light on the UCITS–MiFID Nexus and the Potential Impact of MiFID
on the Asset Management Sector, ECMI Policy Brief No. 12 2008 (ECMI, 2008).
Art. 4(1)(18).
In its MiFID Q and A, the Commission, in confirming the exclusion of life assurance
contracts from MiFID, stated that there were no current plans to extend MiFID’s scope to
life assurance contracts, although it highlighted the substitute products debate.
As has been confirmed by the Commission in its MiFID Q and A.
In response to a question as to the application of MiFID to a product of identical design,
but structured in one case in the form of a deposit (principal guaranteed) with a return
linked to an index, and in the other in the form of an issuer’s structured note, with capital
protected by a guarantee and the return linked to an index, the Commission suggested that
MiFID would only apply to the latter structure: MiFID Q and A.
Including: reception and transmission of orders on behalf of investors in relation to one or
more ‘financial instruments’; execution of such orders; dealing on own account; portfolio
scope of the advice and product distribution regime
203
(broking) (chapter 6), asset management services (for more affluent and
sophisticated investors) and, critically, investment advice (and the related
distribution of products). There are, however, some significant exclusions
from MiFID’s scope from the retail market perspective.82 Article 2(1)(c)
excludes those providing an investment service where it is provided incidentally in the course of a professional activity, and where that activity
is regulated by legal or regulatory provisions or a professional code of
ethics. Similarly, Article 2(1)(j) excludes persons who provide investment
advice in the course of providing another professional activity not covered by MiFID, as long as the advice is not specifically remunerated.
Incidental investment advice by accountants and legal professionals does
not, therefore, require MiFID-authorization. While this might suggest
some risks, investment advice activity would typically be addressed by
the relevant professional bodies, and this approach supports the delivery of advice through a range of channels and, therefore, easier access to
advice.
3. MiFID’s scope: the pivotal investment advice definition
The inclusion of investment advice, which was not addressed in the precursor Investment Services Directive, marks MiFID as a key retail market
measure. Its definition is also a key perimeter for the regulatory regime;
whether or not the service amounts to ‘investment advice’ dictates whether
suitability requirements apply. Investment advice is defined as the provision of ‘personal recommendations’ to a client, either on its request or at
the initiative of the investment firm, in respect of one or more transactions
relating to financial instruments (Article 4(1)(4)). It has been further clarified at level 2, by Article 52 of the MiFID Level 2 Directive, which defines
a ‘personal recommendation’ as one made to a person in his capacity as an
investor or potential investor, presented as suitable for that person or based
on a consideration of the circumstances of that person, and constituting
a recommendation: (a) to buy, sell, subscribe for, exchange, redeem, hold
or underwrite a particular financial instrument; or (b) to exercise, or not
to exercise, any right conferred by a particular financial instrument to buy,
82
management; investment advice; underwriting of financial instruments and/or placing
of financial instruments on a firm commitment basis; placing of financial instruments
without a firm commitment basis; and operation of multilateral trading facilities (MTFs):
Annex I, sect. A.
A wide range of exemptions to MiFID’s scope apply under Arts. 2 and 3, but many of these
are concerned with the professional markets.
204
investment advice and product distribution
sell, subscribe for, exchange or redeem a financial instrument. The personalization of the advice to the client’s personal situation, and the specificity
of the advice given are therefore central to its regulatory characterization
as regulated ‘investment advice’.
This restriction of ‘investment advice’ suggests a somewhat robust
approach to investor protection and a concern to ensure that suitability controls, the most paternalistic expression of investor protection under
MiFID, are confined appropriately, given their costs.83 Although generic
and non-personalized advice falls outside the perimeter, some care will be
needed to ensure the ‘investment advice’ perimeter does not catch activities which are useful for demand-side initiatives which build informed
investors and which should not be subject to costly regulation. Investment
firms’ online self-assessment tools, for example, which require personalized inputs from investors, are a potentially important tool in supporting
investor learning and low-cost access to advice and should be regarded as
distinct from ‘investment advice’.84 The regime also fails to address whether
risk warnings are necessary where the investor receives non-personalized
advice; given the need to build an informed cohort of investors, this
represents a lost opportunity.
4. MiFID’s scope: supporting access to advice?
As discussed in section XII below, support of wider access to investment
advice has emerged as a policy priority. In principle, MiFID should support greater competition in the EC market for advice and so easier access
to competitively priced services. Authorization under MiFID is not only a
prerequisite for the supply of investment services; it supports the MiFID
passport which allows MiFID-authorized firms to provide investment
services in host States,85 anchored to home Member State supervision (for
the most part).86 But whether or not MiFID can support competition in
83
84
85
86
CESR, Technical Advice on Possible Implementing Measures of Directive 2004/39/EC: 1st Set
of Mandates Where the Deadline Was Extended and 2nd Set of Mandates (CESR/05-290b,
2005) (‘2nd Mandate Advice’), p. 7.
The Australian Treasury, for example, regards online calculators as useful in supporting
consumers in understanding and comparing financial services and has undertaken to keep
such tools outside the equivalent ‘personal advice’ characterization: Treasury, Refinements
Proposals.
A host Member State is one, other than the home Member State, in which an investment
firm has a branch or performs services and/or activities: Art. 4(1)(21).
Arts. 31 and 32. Under Art. 32(7), the Member State in which a firm’s branch operates is
responsible for the supervision of certain rules, particularly conduct-of-business requirements.
scope of the advice and product distribution regime
205
cross-border advice services remains unclear.87 Given that investors have
strong preferences for local providers,88 the growth of the pan-EC retail
market is likely to depend on the extent to which firms can disguise themselves, particularly through online services, subsidiaries or branches, as
home firms,89 by operating in investors’ home languages and selling services and products closely linked to the domestic market; cross-border
activity is generally the preserve of the subsidiaries of banks which act
as ‘financial supermarkets’ in continental Europe.90 But whether investment firms and advisers have sufficient incentives to act cross-border is
uncertain,91 particularly given MiFID’s costs. MiFID may lead to a contraction in the advice industry if it consolidates in reaction to an increased
regulatory burden.92 Strong cultural and local factors, different levels of
welfare provision, radically different saving patterns, demographic trends
and differing financial literacy and risk-appetite profiles93 also all impact
on the extent to which investors are willing to engage with the advice
industry.94 The development of smaller, fee-based investment advice firms
87
88
89
90
91
92
93
94
Although the FSA has produced a factsheet explaining to ‘Article 3 firms’ (investment
advice firms exempted from MiFID, discussed below) how they can opt in to MiFID
where they provide cross-border business, it appears to be designed as a guide to MiFID
compliance with respect to pre-existing cross-border relationships, rather than in response
to demand for access to the cross-border advice market: FSA, FactSheet on Financial Advice
and Passporting (2007). Some non-MiFID ‘Article 3 firms’ have, however, opted for MiFID
authorization to benefit from the passport: FSA, Review of the Prudential Regime for Personal
Investment Firms (Feedback Statement No. 08/2, 2008), p. 4.
This is a recurring theme of recent assessments: for example, European Commission,
European Financial Integration Report (SEC (2009) 19), p. 14, and Green Paper on Retail
Financial Services in the Single Market (COM (2007) 226, 2007), p. 6. See also ch. 1.
BME Report, p. 31. The FSA has similarly linked an increase in cross-border merger and
acquisition activity to retail investors’ preference for local providers: FSA, Response to the
European Commission’s Call for Evidence on Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Investment Products (2008)
(‘FSA Substitute Products Response’), p. 4.
See further ch. 1.
UK firms appear sceptical, with only half of those canvassed in one leading survey of the
view that any new opportunities will be material: Europe Economics, The Benefits of MiFID:
A Report for the Financial Services Authority (2006), p. 23.
MiFID’s retail market benefits have been projected as limited to large banks who may gain
business from smaller financial advisers: S. Morris, ‘MiFID – The Winners and Losers’,
Financial World, November 2007, p. 14. The FSA has also suggested that the benefits of
MiFID will be spread unevenly and will mainly accrue to firms operating cross-border:
FSA, The Overall Impact of MiFID (2006).
E.g. HM Treasury, FSA and Bank of England, Supervising Financial Services in an Integrated
European Single Market: A Discussion Paper (2005), p. 13; and A. Knight, ‘MiFID’s Impact
upon the Retail Investment Markets’ in C. Skinner (ed.), The Future of Investing in Europe’s
Markets after MiFID (Chichester: John Wiley & Sons, 2007), p. 207, p. 209.
BME Report, pp. 212–14.
206
investment advice and product distribution
may also be prejudiced by the demands of MiFID’s principles-based model
for smaller firms.95
But MiFID can be regarded as supporting access to advice across two
dimensions: the Article 3 regime, which supports local advice structures;
and the tied agents regime. An important optional exclusion from MiFID
applies under Article 3, which was originally negotiated by the UK to
exempt a significant proportion of its domestic investment advice industry.
Article 3 allows Member States to exempt entities (for which they are
the home Member State) which do not hold client funds or securities,
which only receive and transmit orders with respect to a limited range
of instruments (transferable securities and CIS units), and which provide
investment advice in relation to these instruments.96 As outlined in chapter
1, UK ‘Article 3 firms’ typically provide advice and sales services with
respect to the ‘packaged products’ which dominate in the UK retail market.
While the FSA has subjected these firms to MiFID distribution and advice
rules, for the most part, and while these firms compete with MiFID firms,
the MiFID regime has been tailored under the Article 3 exemption where
the cost of MiFID compliance has been identified as exceeding the benefits,
given the small range of activities these firms engage in and their particular
risk profile. ‘Article 3 firms’ can also deliver low-cost, and less highly
regulated, ex-MiFID ‘Basic Advice’ (section XII below).97 On the other
hand, the parallel operation of MiFID and non-MiFID regimes has the
potential to cause confusion and to generate regulatory arbitrage.98
A new but limited regime, designed to clarify when an investment firm
can use tied agents, also applies to tied agents appointed to act on behalf
of one investment firm.99 The clarification may generate wider access to
95
FSA, Principles-Based Regulation: Focusing on the Outcomes That Matter (2007), p. 18.
The exemption is only available where these entities transmit orders to a range of nominated actors, essentially regulated market participants including investment firms, credit
institutions and CISs.
97
The UK’s ‘Basic Advice’ regime for ‘stakeholder products’ applies to non-MiFID advisers
who do not hold client money and who are exempted under Article 3: FSA, Reforming
Conduct of Business Regulation (Consultation Paper No. 06/19, 2006), p. 82.
98
Concerns were raised during the FSA’s review of the capital resource requirements which
apply to ‘Article 3’ firms as to regulatory arbitrage risks, given, in particular, that some
notional ‘Article 3’ firms have opted for MiFID authorization to benefit from the passport.
These firms are subject to MiFID’s lighter capital adequacy regime for firms which do
not engage in proprietary dealing or hold client assets. The FSA has, nonetheless, limited
its reforms to non-MiFID firms: FSA, Review of the Prudential Rules for Investment Firms
(Consultation Paper No. 08/20, 2008), pp. 4–5.
99
European Commission, Overview of Proposed Adjustments to the Investment Services Directive: Working Document of Services of DG Internal Market: Document 1, July 2001, p. 21.
96
scope of the advice and product distribution regime
207
investment advice by supporting the appointment by firms of tied agents in
other Member States and cross-border distribution and advice structures
which rely on tied agents.100
5. MiFID’s scope: the nature of investor protection ‘on the books’
a) Authorization and prudential requirements
MiFID delivers investor protection in the advice and distribution context across a number of dimensions. MiFID’s authorization requirement
(Article 5) and supporting rules (Articles 6–12) support the investmentservices passport and market integration. But they also support investor
protection by imposing perimeter controls on intermediation. These
perimeter requirements cover initial capital requirements (Article 12),101
management requirements (in the form of ‘fit and proper’ requirements)
(Article 9), programme of business requirements (Article 7(2)) and shareholder review requirements (Article 10).
MiFID’s extensive operational or ongoing prudential regime, and,
in particular, its organizational risk-management rules and its ongoing
capital-adequacy regime,102 is designed to support firm stability and ability to withstand risk events. The organizational risk management regime
(Article 13) has been amplified by the MiFID Level 2 Directive which covers decision-making, internal controls and risk management, employee
competence, internal reporting, record-keeping, data protection, business
continuity, accounting and monitoring (Article 5), and senior management responsibility (Article 9), as well as the compliance (Article 6),
risk management (Article 7) and internal audit (Article 8) functions. It
also addresses the outsourcing of ‘critical or important operational functions’ (Articles 13–15) and record-keeping (Article 51). An extensive asset
protection regime applies under Articles 16–20 and reflects the MiFID
Article 13(7) and (8) obligation to maintain asset and money protection
systems.
100
101
102
Art. 23. The defining characteristic of a tied agent under MiFID is that the agent operates
under the sole responsibility of the appointing investment firm.
Initial capital requirements for investment firms range from €125,000 to €730,000 depending on the services carried out and, in particular, or whether the firm deals on own account
and so faces trading risk.
The capital adequacy requirements imposed on investment firms are governed by the
2006 Capital Requirements Directive which is composed of Directive 2006/48/EC, OJ 2006
No. L177/1 and Directive 2006/49/EC, OJ 2006 No. L177/201.
208
investment advice and product distribution
These prudential rules have important implications for investor protection by supporting the stability of the firm. Prudential requirements also
play an important role in supporting firm sustainability and accordingly
access to advice.103 More specifically, prudential rules are also particularly
significant for asset management services where assets are transferred
to the investment firm. This is reflected in the level 2 outsourcing regime
which, in addition to the general conditions which apply to outsourcing,104
imposes specific requirements, linked to the authorization of, and supervisory co-operation with respect to, the outsourcing service provider.105
The extensive asset protection regime is also an essential protection against
investment firm fraud, incompetence or insolvency. It addresses asset segregation and record-keeping, when client deposits and instruments may
be held with third parties, the circumstances in which an investment firm
may use client instruments on own account (and the conditions to which
firm stock-lending is subject) and external auditing of asset protection
arrangements.106
b) Conduct-of-business regulation and
conflict-of-interest management
Although they are important investor protection mechanisms, prudential
organizational and capital requirements are firm- rather than investorfacing,107 particularly with respect to their supervision and enforcement.
But they remain closely related to individual investor protection in the conduct of the adviser/investor relationship, given, in particular, the influence
of firms’ systems and quality controls on the investor experience, particularly in large firms.108 Conduct-of-business and conflict-of-interest
management rules, however, have a direct bearing on the firm/investor
relationship and are on the frontline of investor protection; FSA research
suggests that capital rules have only an indirect bearing on the prevention of mis-selling and that conduct-of-business rules and fair treatment
principles are more cost effective and efficient in addressing the quality
103
104
105
106
107
108
The UK FSA has frequently associated prudential and soundness rules with good retail
market outcomes: FSA, Major Retail Thematic Work Plan for 2008–2009, p. 1.
MiFID Level 2 Directive, Art. 14.
Ibid., Art. 15 (the regime applies to outsourcing to third countries).
On the importance of asset protection rules, see J. Franks, C. Mayer and L. Correia da
Silva, Asset Management and Investor Protection: An International Analysis (Oxford: Oxford
University Press, 2003), pp. 17–18 and 88.
D. Gros and K. Lannoo, The Euro Capital Market (Chichester: John Wiley & Sons, 2000),
p. 122.
FSA, Consumer Responsibility (Discussion Paper No. 08/5, 2008), highlighting the importance of systems and prudential requirements to investor protection (p. 23).
regulatory design choices
209
of advice.109 Nonetheless, the efficacy of conduct rules depends on the
quality of the firm’s systems and resources.
MiFID’s major retail market innovation concerns its adoption of a
detailed conduct-of-business and conflict-of-interest regime. Along with
the disclosure regime discussed in chapter 5, these rules form the frontline
of MiFID’s protections. The Article 19 conduct-of-business regime and
its extensive level 2 rules, in particular, establish an investor protection
code which addresses risks in the investor/investment firm relationship
through a foundation fair treatment obligation, marketing rules, processbased suitability/know-your-client requirements, disclosure and reporting
rules and contract requirements. Although conduct-of-business rules can
be regarded as rooted in private bargaining and as optional, default contract rules,110 the regime suggests a concern to protect the vulnerable
trusting investor, as its protections must be applied to retail investors;
retail investors may only ‘opt out’ where they can be treated as ‘professional’ investors following a request to be so classified.111 The stringent
conditions which apply make it unlikely that mass market consumers of
investment products will be able to opt out, while the extensive procedural requirements suggest that any opt-out will only take place where the
investor clearly understands the implications and the firm is confident as
to the appropriateness of the professional designation.112 This approach
reflects that of the Distance Marketing of Financial Services Directive
(DMD), which provides that consumers may not waive Directive rights
(Article 12). But MiFID also reflects some degree of investor autonomy:
the nature of the suitability protections provided reflects the service provided and the degree of reliance by the investor on the investment firm
(section VI below).
III. Regulatory design choices
1. Regulatory design choice (1): maximum harmonization
MiFID’s effectiveness with respect to advice and distribution is in large part
hostage to the success of its three major and interlinked design choices:
109
110
111
112
FSA, Feedback Statement No. 08/2.
G. Ferrarini, ‘Contract Standards and the Markets in Financial Instruments Directive:
An Assessment of the Lamfalussy Regulatory Architecture’ (2005) 1 European Review of
Contract Law 19.
MiFID, Annex II, sect. II.1. See further ch. 2.
MiFID, Annex II, sect. II.2, imposes detailed procedural requirements.
210
investment advice and product distribution
maximum harmonization; principles-based regulation; and conductshaping regulation.
Article 4 of the MiFID Level 2 Directive113 represents an important innovation for EC harmonization by prohibiting Member States from adopting
rules for their local markets which are additional or super-equivalent to
the MiFID regime; by contrast, the Unfair Commercial Practices (UCP)
Directive contains an express derogation for financial services, in respect
of which Member States may impose more restrictive or prescriptive measures, given ‘their complexity and inherent serious risks’ (recital 9).114
Article 4 raises considerable centralization risks for the retail market, not
simply because investment behaviour varies across the EC, but also given
variations in advice and product distribution channels and in the related
risks to investors (section X below). While certain risks are repeatedly
raised by domestic regulators with respect to advice and distribution,
notably commission risk and quality of advice risks, their effective treatment requires that rules reflect local market characteristics. While MiFID’s
principles-based approach suggests that flexibility and diversity is supported, this comes at the level of the firm and of practical supervision.
The effect of Article 4 is that flexibility and diversity are not supported
by the regulatory regime and that the risks of poor regulatory design are
magnified.
The UK experience provides an instructive example. As noted in chapter
1, long-term and often complex packaged investment products (such as
CISs and unit-linked insurance) dominate in the UK retail market and
are typically distributed or sold by commission-based advisers. This raises
sharp conflict-of-interest and disclosure risks for retail investors and has
led the FSA to adopt a tailored cross-sector regime for the sale of ‘packaged products’. In order to protect the packaged product regime, the
UK Treasury made an Article 4 notification to the Commission.115 The
application116 highlighted the importance of private welfare provision in
113
115
116
See further chs. 1 and 2. 114 Art. 3(9).
HM Treasury, Notification and Justification for Retention of the FSA’s Requirements on the
Use of Dealing Commissions under Article 4 of Directive 2006/73/EC Implementing Directive
2004/39/EC and Notification and Justification for Retention of Certain Requirements Relating
to the Market for Packaged Products under Article 4 of Directive 2006/73/EC Implementing
Directive 2004/39/EC (2007) (‘UK Article 4 Application’).
The ‘notified’ rules cover: (i) the conditions advisers must meet to call themselves ‘independent’ (the firm must advise on the ‘whole of the market’ and offer clients a fee option
with respect to remuneration); (ii) the provision of a UCITS simplified prospectus or
KFD; (iii) the disclosure of actual commissions and commission equivalents with respect
to the sale of packaged products; and (iv) the use of dealing commission. The FSA based
its identification of necessary Article 4 rules on the extent to which there were likely to be
regulatory design choices
211
the UK, as well as the higher proportion of home ownership which led to
investments being relied on to repay mortgage debt.117 It underlined the
FSA’s extensive testing efforts, which pointed to an investor base which
struggled in understanding the risks of often complex products and had
little experience in choosing products, the complex charging structures
often employed and the danger that risks would typically take a long time
to emerge.118 The application also pointed to heavy reliance on advisers
and risks from incentive misalignment in commission-based advisers and
from investor reluctance to pay a fee for investment advice, which had led
to a series of mis-selling scandals.119 Although public statements by Commissioner McCreevy had previously suggested some Commission hostility
to Article 4 applications,120 the application was successful.121 The Commission also appears willing to characterize certain local rules as simply
more specific applications of general MiFID rules and falling outside the
notification obligation.122
Nonetheless, some nervousness is warranted, particularly as Article 4
appears to have influenced the FSA’s decision to remove its pre-MiFID
requirement that investment advisers, when advising on packaged products, provide advice as to the ‘most suitable’ product in the range on which
they advise. Although the FSA has pointed to MiFID’s matrix of conflictof-interest, disclosure and suitability rules, consumer stakeholders have
called for the potential effects of the changes to be monitored.123 Article
4, in combination with MiFID’s adoption of a high-level, principles-based
approach to disclosure and marketing communications, has also raised
concerns as to standardization and comparability risks;124 so too has the
117
120
121
122
123
124
material market failures and investor protection risks in the UK market which were not
adequately addressed by MiFID: FSA, Reforming Conduct of Business Regulation (Policy
Statement No. 07/14, 2007), p. 5.
UK Article 4 Application, pp. 11–12. 118 Ibid., p. 12. 119 Ibid., pp. 12–14.
Commissioner McCreevy, Speech on ‘Integration of Financial Markets in the Context of Globalisation’, High-Level City Group, 20 February 2007, available via
http://europa.eu/rapid/searchAction.do.
A senior FSA official commended the Commission’s ‘sensible and proportionate’ approach:
D. Waters, Speech on ‘MiFID, Threats and Opportunities’, Insurance Institute of
London, 9 January 2008, available via www.fsa.gov.uk/Pages/Library/Communications/
Speeches/index.shtml.
This was the case with the FSA’s suitability letter (sect. VI below) which the Commission
regarded as a local application of the Art. 19(8) record-keeping obligation: FSA, Reforming
Conduct of Business Regulation (Policy Statement No. 07/6, 2007), p. 5.
Ibid., p. 50.
See further ch. 5. Concerns have been highlighted with respect to the adoption of a highlevel approach to projections and past performance disclosure in particular: Financial
Services Consumer Panel (FSCP), Annual Report 2007–2008, p. 38.
212
investment advice and product distribution
MiFID-driven removal of the previously detailed FSA requirements which
applied to the content of the investor/investment firm contract.125 It would
make little sense if MiFID’s much-trumpeted retail investor protection
regime were to result in the elimination of local rules expressly designed
to protect investors in a particular risk environment. Nonetheless, Article
4 generates this risk. The Commission does, however, appear open to the
need to retain some regulatory diversity in the retail markets. The pan-EC
systemic risk of poor regulatory design remains, however, significant.
2. Regulatory design choice (2): principles-based regulation
Although the desirability or otherwise of a principles-based model was
not discussed during the level 1 negotiations, the Commission adopted a
principles-based approach during the level 2 negotiations for the pivotal
conduct-of-business and conflict-of-interest management regimes. It was
at some pains to assert that the MiFID Level 2 Directive focuses on the
standards and objectives which investment firms must attain, rather than
on detailed, prescribed rules, describing it as a ‘principles-based but tightly
worded Directive’.126 The Directive is asserted to create ‘strong incentives’
for firms to monitor their activities and to assess whether they are in
compliance with the Directive’s principles and to avoid the restrictions
of ‘one-size-fits-all’ models.127 The level of prescription in both the conduct regime and the conflicts regime might be regarded as diminishing
MiFID’s claim to be principles-based.128 But a wholesale adoption of a
principles-based approach was neither practical nor feasible; the question
is as to whether the appropriate balance is maintained between rules and
principles.129 Overall, a focus on outcomes, process and firm judgment
strongly characterizes the MiFID regime.
125
126
127
128
129
FSCP, Response to Consultation Paper 06/19 and Consultation Paper 06/20, Reforming
Conduct of Business Regulation (2006), p. 3; and FSCP, Annual Report 2007–2008, p. 38.
Background Note to the Draft Commission Directive implementing Directive 2004/39/EC
as regards organisational requirements and operating conditions (February 2006) (Background Note), p. 5.
Ibid., pp. 5–6. Recital 11 to the Level 2 Directive states that a ‘regulatory regime should be
adapted to [investment firm] diversity while imposing certain fundamental requirements
which are appropriate for all firms’.
I. Mason, ‘Principles-Based Regulation – Will It Work?’ in Skinner, Future of Investing,
p. 85.
W. Buiter, Lessons from the 2007 Financial Crisis (Centre for Economic Policy Research,
Policy Insight No. 18, CEPR, 2007), p. 3.
regulatory design choices
213
The principles-based model is well illustrated by MiFID’s reliance on
a general fiduciary-style fair treatment obligation for firms to act in the
‘best interests’ of clients (Article 19(1)) and its requirement that all firm
communications with investors be ‘fair, clear and not misleading’ (Article
19(2)). The level 2 conflicts-of-interest regime is similarly designed to
be principles-based and to ‘ensure that investment firms take a holistic
approach to conflicts management, regularly reviewing their business lines
to ensure that at all times their policies reflect the full scope of their
activities and the possible conflicts that may emerge’.130
The principles-based model is also reflected in MiFID’s generic
approach to retail market risks. Some considerable strains are placed on
MiFID’s generic advice and product distribution regime where it intersects
with financial market innovation, evolving conflict-of-interest risk (such
as the greater pressure on firms to chase commissions and sales in the current bear market) and fast-developing and complex products, including
UCITS III products, structured securities and alternative investments.
MiFID’s success ‘in action’ is accordingly closely tied to its doubtful ability to contain the particular risks associated with principles-based
intervention. The ‘credit crunch’, however, appears to have placed MiFID’s
principles-based approach under strain given concerns as to the effectiveness of advice disciplines in the sale of structured products.131
3. Regulatory design choice (3): shaping firm conduct and the
eclipsing of disclosure
MiFID is also strongly associated with the eclipsing of disclosure and with
a sharper focus on the supply-side reforms associated with support of the
trusting investor. Reflecting a more interventionist approach to the retail
markets, MiFID embraces a ‘conduct-shaping’ style of regulation,132 which
emphasizes the firm/investor fiduciary relationship133 and which limits the
extent to which disclosure and investor consent, strongly associated with
130
131
132
133
Background Note, p. 13.
CESR, The Lehman Brothers Default: An Assessment of the Market Impact (CESR/09-255,
2009), p. 3.
The Commission has described MiFID as entailing ‘reinforced fiduciary duties [which]
protect consumers by enhancing responsible behaviour by firms’: European Commission,
Retail Financial Services Green Paper, p. 12.
And so reflects the view that intermediary regulation tends to be consumer-oriented and
to protect investors against the abuse of fiduciary duties: T. Frankel and L. Cunningham,
‘The Mysterious Ways of Mutual Funds: Market Timing’ (2006) 25 Annual Review of
Banking and Financial Law 235.
214
investment advice and product distribution
empowerment strategies, can serve to ensure compliance with regulatory
requirements.134
Nonetheless, and as discussed in chapter 5, disclosure persists as a regulatory technique135 for managing the investor/firm relationship and is
‘designed to give regulators and investors the necessary tools to . . . discern
and punish inefficiency and unprincipled conduct by firms’.136 The Commission, however, sought to limit disclosure and to ‘reinforce the fiduciary
duties of firms’ through the conduct-of-business regime.137 Disclosure is
limited to those elements essential for retail investors to understand the
nature of the investor/firm relationship, and the Commission was concerned to ‘avoid overloading clients with information of no immediate
use’.138 Investor protection under MiFID is accordingly designed to be
primarily a function of the firm’s duties to the investor, rather than of
the investor’s ability to make rational, disclosure-based decisions.139 A
similar approach has been adopted with the conflict-of-interest regime.
Organizational requirements are at the heart of the regime, reflecting the
assumption that ex ante prevention of conflicts of interest is more effective than ex post review and disclosure.140 Simple disclosure of conflict
134
135
136
137
138
139
140
This is most apparent in the suitability regime, under which the firm cannot proceed
where certain disclosures are not provided, and in the conflicts-of-interest regime, where
disclosure of an inducement is not sufficient to comply with MiFID where the inducement
does not enhance the delivery of the service.
The EC is not alone in finding it difficult to shake off the attractions of disclosure. Elaborate
mandatory disclosure obligations, concerning in particular compensation, conflicts of
interest and the suitability of investment advice, apply in the US: Jackson, ‘Regulation’;
and, in the asset management context, Franks et al., Asset Management.
Background Note, p. 16.
Commission Working Document EC/24/2005, Explanatory Note to ESC/23/2005 (July
2005) (‘July 2005 Explanatory Note’), p. 1.
Ibid., p. 2. The Commission’s Director of Financial Services Policy and Financial Markets
described MiFID’s ‘regulatory philosophy’ in terms of high levels of investor protection and limited reliance on disclosure: D. Wright, Presentation on Markets in Financial
Instruments Directive, 27 October 2007, available via http://ec.europa.eu/internal market/
securities/isd/mifid en.htm. The Commission’s FAQ document issued on the eve of
MiFID’s application similarly stated that MiFID was designed not to flood consumers
‘with reams of information which may not be relevant to them and which they may have
difficulty understanding. Instead, the emphasis will be on the fiduciary duties of firms
towards their clients’: European Commission, Markets in Financial Instruments Directive:
Frequently Asked Questions (2007).
The Commission has described MiFID in terms of ‘specific attention [being] granted to
retail clients for which a specific regime has been established, which entails reinforced
fiduciary duties upon the firm’: Green Paper on Retail Financial Services, p. 12.
D. Cain, G. Loewenstein and D. Moore, ‘The Dirt on Coming Clean: Perverse Effects of
Disclosing Conflicts of Interest’ (2005) 34 Journal of Legal Studies 1. ASIC has concluded
the fairness principle and ‘law in action’
215
of interests is not sufficient to meet the conflicts obligation (recital 27)
and, although disclosure is relied on as a strategy for managing conflict of
interests, it is not a panacea but a last resort.141
While attuned to the trusting investor in that it downplays disclosure,
the conduct-shaping approach, in combination with principles-based regulation, is not without risk, particularly given limited Member State discretion by virtue of Article 4, unless careful attention is paid to regulatory
design ‘in action’. MiFID’s standards grapple with nebulous regulatory outcomes such as ‘fairness’ (Article 19(1)), that disclosure is ‘fair, clear and not
misleading’ (Article 19(2)) and that investment advice is ‘suitable’ (Article
19(4)). These concepts are difficult to articulate as regulatory prescriptions. They have the potential to support an outcomes-based approach
to retail market regulation and to capture the ever-increasing complexity
of markets and changing market conditions.142 But, as discussed in the
next section, significant cultural and organizational change, supported by
sophisticated supervision, appears necessary to entrench principles-based,
firm-facing obligations and, accordingly, to support effectively trusting
and empowered investors.
IV. Regulatory technique (1): the fairness principle and
‘law in action’
1. The fair treatment principle
A foundation fiduciary-style obligation to act fairly in the client’s best
interests is imposed on investment firms under Article 19(1). The ‘fair
treatment’ principle requires a firm to act honestly, fairly and professionally in accordance with the best interests of its clients when providing
investment services (and to comply with the Article 19(2)–(8) conduct-ofbusiness principles). Save with respect to the inducements regime (section
X below), the principle has not been amplified at level 2. Fairness is, however, a recurring theme of MiFID’s investor protection regime. Disclosure
must be ‘fair, clear and not misleading’ (Article 19(2)). In the execution
context, client orders must be handled in a manner which provides for
their ‘prompt, fair, and expeditious’ execution (Article 22(1)) and firms
must adopt a policy for the ‘fair allocation’ of orders (MiFID Level 2
141
that disclosure is rarely sufficient to manage conflicts of interest and accompanying internal
controls are needed: ASIC, Managing Conflicts of Interest in the Financial Services Industry
(Consultation Paper No. 73, 2006).
Background Note, p. 14. 142 Jackson, ‘Regulation’.
216
investment advice and product distribution
Directive, Article 48). The inducements regime is related to whether the
inducement prevents a firm from acting honestly, fairly and professionally in the best interests of the investor (MiFID Level 2 Directive, Article
26). The extensive disclosure regime incorporates fairness requirements,
including that the potential benefits of a service or instrument must not
be emphasized unless a ‘fair and prominent’ indication is given of risk and
that comparisons must be presented in a ‘fair and balanced way’ (Article
27) and information on guarantees must allow the retail investor to make
a ‘fair assessment’ (MiFID Level 2 Directive, Article 31). MiFID’s reliance
on fairness also reflects a wider reliance on fairness in the background
consumer protection regime. The Unfair Contract Terms Directive prohibits terms determined to be unfair (section VII below), while, in the
marketing context, the Unfair Commercial Practices Directive prohibits
unfair practices (section V below).
Although fairness is a troublesome and inchoate concept, it is often
associated with investor protection.143 Its adoption in Article 19(1)
injects a protective element into MiFID and suggests a withdrawal from
empowerment-driven disclosure techniques. It reflects support for a trusting model of the retail investor by assuming that investor engagement with
investment firms, given the imbalance in bargaining power and the expectations, however flawed, of retail investors, should be imbued with some
sense of fairness – however shadowy a notion this is.144
While an appealing notion, the injection of an undefined fairness obligation carries considerable risks in terms of the potential for flawed ex
post review, but also given that that fairness assessments may become
an occasion for value judgments on the investment process (section IV.2
below). The risks may be balanced by the need to focus on law ‘in action’
in supporting empowered and trusting investors in volatile, evolving and
complex markets and given the risks of regulatory design. Prescriptive rules
are problematic in terms not only of design but also of compliance.145 An
umbrella fair treatment obligation may allow regulatory authorities to
143
144
145
Fair access to disclosure was controversially pursued by the SEC in its Regulation FD which
prevents issuers from making selective disclosure to analysts in particular; ‘prompt and
fair disclosure of information’ is also sought by the EC’s prohibition on selective disclosure
(European Parliament and Council Directive 2003/6/EC of 28 January 2003 on insider
dealing and market manipulation, OJ 2003 No. L96/16, Art. 6(3)). The rhetoric of ‘fair
and orderly markets’ is also long-established: C. Bradley, ‘Disorderly Conduct and the
Ideology of “Fair and Orderly Markets”’ (2000) 26 Journal of Corporation Law 63.
Reliance on ‘fairness’ concepts in financial market regulation has been described as reflecting a ‘consumerist theme’: Benjamin, Financial Law, pp. 563 and 571.
E.g. sect. VI below on suitability rules.
the fairness principle and ‘law in action’
217
drive closer engagement by firms with the needs of retail investors and
to achieve more effective investor protection ‘in action’,146 particularly
with respect to those risks not expressly addressed by rules147 and those
which develop in the future. The fair treatment principle also provides
supervisors and courts with an ex post mechanism for reviewing investment firm behaviour. Fairness might also be associated with an ethicsand trust-based approach to the achievement of regulatory objectives148
which, assuming that the embedding of ethics provides better incentive
alignment than close supervision of prescriptive rules, might lead to better
investor outcomes in practice.149
2. The risks of ‘fairness’
But fairness is a complex objective to achieve. Any regulatory ‘marketing’ dynamic to the effect that firms behave fairly may be troublesome
given investor over-reliance on advice. Interpretation difficulties are considerable. The legislative history of Article 19(1) casts little light on the
meaning of fairness. As it is likely to reflect local market conditions and
traditions,150 fairness is likely to generate widely varying interpretations.151
Although supervisory convergence through CESR may support a consistent approach by supervisors, it is considerably more difficult to achieve
pan-EC consistency of judicial interpretations, absent a ruling from the
European Court of Justice; the Commission has, however, established a
database of national rulings in the unfair contract terms sphere which
146
147
148
149
150
151
Under Art. 19(1), ‘it will never be enough for firms to comply with the specific conflict-ofinterest rules . . . [They will] always have to ensure that their clients are treated honestly,
fairly, and professionally’: L. Enriques, ‘Conflicts of Interest in Investment Services: The
Price and Unfair Impact of MiFID’s Regulatory Framework’ in G. Ferrarini and E. Wymeersch (eds.), Investor Protection in Europe: Corporate Law Making, the MiFID and Beyond
(Oxford: Oxford University Press, 2006), p. 321, p. 326.
Recital 81 to the Level 2 Directive, for example, applies Art. 19(1) to the provision of
generic advice which is not subject to the MiFID suitability regime.
The move to principles-based regulation has been associated with the support of ethics
as a means of disciplining firms: L. Cunningham, A Prescription to Retire the Rhetoric of
‘Principles-Based Systems’ in Corporate Law, Securities Regulation, and Accounting (2007),
ssrn abstractid=970646, p. 52. The fiduciary relationship has also been characterized in
terms of trust: M. Blair and L. Stout, Trust, Trustworthiness, and the Behavioral Foundations
of Corporate Law (2000), ssrn abstractid=241403, p. 3.
D. Langevoort, ‘Monitoring: The Behavioral Economics of Corporate Compliance with
Law’ (2002) Columbia Business Law Review 71.
Enriques, Conflicts of Interest, p. 333.
M. Hopper, ‘The MiFID Measure’ (2006) 64 European Lawyer 9.
218
investment advice and product distribution
might usefully be replicated.152 The difficulties will be all the greater if
firms prefer to settle with regulators rather than carry the risks of fairnessbased enforcement action.153 Ultimately, if divergent and unpredictable
ex post interpretations are accompanied by increased enforcement costs,
reputation risks or litigation risk,154 the sustainability of an innovative
distribution and advice industry and firms’ willingness to carry the costs
of retail market activity may be threatened. Over-investment in compliance may also follow which can lead to mistrust within firms and a
hampering of innovation.155 On the other hand, this very diversity may
become a strength which allows the regime to respond to different market
contexts.
The risks are also considerable if the fairness obligation becomes a supervisory or judicial occasion for reflecting, ex post, wider societal discontent
with the financial markets, particularly in times of market turbulence;156
the ‘credit crunch’ period may prove revealing. They are also considerable
if ex post assessment focuses on whether a particular outcome or approach
was ‘good’ or in some way the ‘best’ one for the investor. Any move in
this direction would suggest a merit-based and paternalistic approach to
regulation which has been out of favour for some time. It would also sit
uneasily with MiFID’s regulatory focus on a matrix of process/systemsbased, suitability/conflict-of-interest rules, rather than on a requirement
to advise on the ‘best’ product, necessitating a change to the UK’s ‘most
suitable’ regime. It might be suggested that notions of fairness should
therefore be imbued with countervailing reasonableness criteria. Reasonableness is a recurring theme of the MiFID conflicts-of-interest regime,
for example (firms must take ‘all reasonable steps’ to identify conflicts
of interest) (Article 13(3)), and also appears in the suitability regime
152
153
154
155
156
The Commission’s CLAB database on the Unfair Contract Term Directive collates decisions
by administrative bodies, voluntary agreements, out-of-court settlements and arbitration
awards.
One assessment has pointed to the risk that FSA settlements on TCF violations could
lead to artificial, customer-oriented precedents on what is ‘fair’: Freshfields Bruckhaus
Deringer, Fairness in the UK Financial Services Sector, Briefing March 2008, pp. 1–2.
Cunningham has cautioned against vague concepts, such as fairness, given the risk of
arbitrary enforcement: Prescription, p. 19.
Ambiguous standards may lead compliance departments, seeing rent-seeking opportunities from ambiguity, to overstate compliance requirements and acquire excessive resources:
Langevoort, ‘Behavioral Economics’, 100.
Enforcement based on principles can become imbued with societal values or reflect public
outrage with perceived unfairness in securities markets, by comparison with rule-based
enforcement which emerges from consultation and cost/benefit analysis: J. Park, ‘The
Competing Paradigms of Securities Regulation’ (2007) 57 Duke Law Journal 625.
the fairness principle and ‘law in action’
219
(firms must have a ‘reasonable’ basis for believing that a transaction is
suitable (MiFID Level 2 Directive, Article 35(1))).
The extent to which fairness drives more effective investor protection ‘in
action’ also depends on how it is embraced by national regulators. The UK
experience points to the power of ‘fairness’ as an animating principle which
may lend coherence and focus to rule-making and to supervisory efforts.
The FSA has placed fairness at the heart of its retail market regime157 and
has identified it as a motivating principle in its shaping of the wider UK
and EC regulatory environment.158 Since 2002, it has adopted ‘ensuring a
fair deal for retail consumers’ as its retail market strategic aim.159 Fairness
is also at the centre of its firm-facing Treating Customers Fairly (TCF)
initiative under which fairness is not an abstraction; the TCF initiative has
produced a detailed and practically oriented articulation of what fairness
demands operationally in terms of firm structures and process and, as
such, carries risks.
3. Fairness and the TCF model: ‘law in action’
Compliance with a high-level, ill-defined fairness principle is likely to be a
challenge to achieve organizationally as the challenges posed by the embedding of a particular ethics culture are considerable.160 Employees already
have different incentives to firm managers and owners. Misalignment may
be exacerbated where they are expected to pursue principles which are
not carefully delineated, and where immediate employee incentives are in
conflict with long-term firm objectives concerning fair treatment,161 as
has been acknowledged by the FSA’s TCF initiative.162
The UK experience with the TCF strategy is instructive. UK investment
firms operate under MiFID’s conduct-of-business regime which has been
largely ‘copied out’ in the FSA’s Conduct of Business Sourcebook. But,
157
158
159
160
161
162
The TCF objective has been described as a ‘core means of fulfilling the FSA’s consumer
protection objective’: FSCP, Annual Report 2007–2008, p. 6.
FSA, Business Plan 2008–2009, p. 23. The FSA’s decision to move from the previous selfregulatory model in the banking conduct-of-business sphere to a regulatory model, for
example, is based in part on the absence of an over-arching fairness obligation: FSA,
Regulating Retail Banking Conduct of Business (Consultation Paper No. 08/19, 2008),
p. 4.
See further ch. 2.
J. Edwards, ‘Treating Customers Fairly’ (2006) 14 Journal of Financial Regulation and
Compliance 242, 246.
Langevoort, ‘Behavioral Economics’, 107.
FSA, Remuneration: Considerations for Treating Customers Fairly.
220
investment advice and product distribution
in practice, compliance with the conduct-of-business regime is also a
function of the FSA’s TCF initiative which operates in parallel with MiFID.
The TCF initiative, which took root in 2004163 and is now an ‘over-arching
priority’ for the FSA’s retail work,164 central to the fair deal objective165 and
embedded in its supervisory framework,166 is based on Principle 6 of the
FSA’s eleven high-level Principles for Business. In a formula akin to Article
19(1), which has been directly implemented in the Conduct of Business
Sourcebook,167 Principle 6 requires that a firm pay due regard to the
interests of its customers and treat them fairly. The related TCF initiative
represents a considerable shift from a ‘laws on the books’ approach in that it
adopts strategies which are expressly designed to ‘change firms’ behaviour
in order to deliver fairer outcomes for consumers’ while ‘recognizing the
scale of cultural change’ within firms which it seeks.168
The TCF initiative is not based on the production of additional rules.169
Partly in response to repeated instances of mis-selling, including the splitcapital trust and precipice bonds failures (and the related failure of prescriptive regulation),170 which were dealt with by a discouraging cycle of
mis-selling, loss, enforcement and reform, it is designed to focus senior
management attention on the delivery of fair outcomes, embed a ‘TCF
culture’ and allow firms flexibility in delivering the TCF outcomes. The
six TCF outcomes address core aspects of the investment life-cycle and are
designed to provide a description of the characteristics of a retail market in
163
164
165
166
167
168
169
170
For an early discussion, see FSA, Treating Customers Fairly – Progress and Next Steps (2004).
FSA, Treating Customers Fairly Initiative: May 2007 Progress Report (2007), p. 8.
The FSA’s Major Retail Thematic Work Plan for 2008–2009 highlighted that ‘TCF is the
cornerstone of our efforts to help consumers achieve a fair deal and underpins much of
our thematic work’ (p. 1).
From January 2009, delivery of TCF outcomes was to be tested as part of a firm’s usual
supervision by the FSA, embedded within the FSA’s supervisory framework, and to become
‘an integral part of regular assessments of relationship managed firms’: FSA, Press Release,
12 November 2008 (FSA/PN/130/2008).
COBS 2.1.1. The FSA has described Art. 19(1) as a high-level requirement which overlaps
with the existing Principles for Business, including Principle 6: Consultation Paper 06/19,
p. 30.
FSA, Transparency as a Regulatory Tool (Discussion Paper No. 08/3, 2008), p. 49.
‘[The FSA is] reluctant to press on with ever more intrusive regulation, which could create
defensive and costly markets which are smaller and less innovative. Instead, we would prefer
to see our rules supported by an intelligent, thoughtful, and effective implementation by
firms of the high-level principle that they must Treat Customers Fairly’: FSA, Progress and
Next Steps, p. 4.
S. Wilson (FSA), Speech on ‘Treating Customers Fairly – Progress and Next Steps’,
19 March 2007, available via www.fsa.gov.uk/Pages/Library/Communications/Speeches/
index.shtml.
the fairness principle and ‘law in action’
221
which customers are treated fairly.171 TCF material has been produced on
the three key retail market elements: product design, distribution (including on the quality of advice, remuneration and managing conflicts of
interest) and disclosure (including on marketing and promotion). The
strategy also covers contractual matters and unfair contract terms.
The TCF outcomes are related to the MiFID conduct-of-business regime
but are considerably more operational; the fairness principle, far from
being nebulous, becomes a detailed and practical manual for how firms
should design procedures and processes which address risks to the fair
treatment of investors. The TCF strategy is designed to drive firms to
review their business models and to embed a long-term ‘TCF culture’,
through ‘awareness’, ‘strategy and planning’, ‘implementing’ and ‘embedding’ stages;172 all of this is a very long way from the stark Article 19(1)
‘law on the books’ formula. Firms were to have evidence in place to test
TCF by March 2008 and to be able to demonstrate that they were treating
customers fairly by December 2008. The extent of the FSA’s commitment
to the TCF model became clear during 2008 when, in the teeth of market
turbulence and with a sharp market and political focus on the FSA’s effectiveness in managing wider prudential and liquidity risks, it described the
TCF initiative as central to its work in ensuring a fair deal for customers
and warned that, notwithstanding difficult economic conditions and market turbulence, it would not be diverted from the March and December
deadlines and urged firms to continue with their TCF programmes.173
Firms are supported in delivering the TCF outcomes through a wide
array of non-regulatory tools including examples of best practice, case
studies, FAQs, self-assessment tools (particularly for smaller firms, who
171
172
173
The six outcomes are: (i) consumers can be confident that they are dealing with firms
where the fair treatment of consumers is central to the corporate culture; (ii) products
and services marketed and sold in the retail market are designed to meet the needs of
identified consumer groups and are targeted accordingly; (iii) consumers are provided
with clear information and are kept appropriately informed before, during and after the
point of sale; (iv) where consumers receive advice, the advice is suitable and takes account
of their circumstances; (v) consumers are provided with products that perform as firms
have led them to expect, and the associated service is both of an acceptable standard and
as they have been led to expect; and (vi) consumers do not face unreasonable post-sale
barriers imposed by firms to change product, switch provider, submit a claim, or make
a complaint: for example, FSA, Treating Customers Fairly – Towards Fair Outcomes for
Consumers (2006).
FSA, Progress Report May 2007, pp. 2–3.
FSA, Meeting the 2008 Deadlines – An Update for Firms (2008); and FSA, Business Plan
2008–2009, p. 24. Nonetheless, some downgrading of supervisory efforts appears to have
occurred as the credit crunch intensified in autumn 2008 (n. 188 below).
222
investment advice and product distribution
receive close supervisory attention under the TCF framework174 ), assistance in the design of the management information required to evidence TCF outcomes175 and a TCF ‘culture framework’ which highlights
the importance of senior management engagement with TCF (including
the appropriate design of incentive schemes).176 Monitoring,177 industrywide thematic review,178 supervision and, where necessary, enforcement
tools179 are all wielded by the FSA.
Despite this investment in supervisory technology, the FSA has faced
difficulties in ensuring the TCF initiative is embedded, particularly within
smaller firms where investors may be more vulnerable.180 The FSCP is,
however, supportive181 and consumers appear to be reasonably confident that they are receiving fair treatment generally, although confidence
is shaky.182 The critical translation of TCF initiatives from implementation into enhanced outcomes for retail investors, the acid test for its
174
175
176
177
178
179
180
181
182
The FSA has adopted an enhanced strategy for small firm TCF supervision. The FSA’s
June 2008 progress update on firms’ TCF management information systems, for example,
includes specific case studies for small firms: FSA, Treating Customers Fairly: June 2008
Progress Update (2008), Annex 2A.
FSA, A Guide to Management Information (2007). Progress in preparing management
information to evidence the achievement of TCF outcomes was measured in June 2008,
with variable results: FSA, Progress Update June 2008.
FSA, Treating Customers Fairly – Culture (2007). The culture framework addresses: leadership; strategy; decision-making; controls; internal communication; recruitment; training
and competence; and rewards.
A series of reports addressed progress under the TCF initiatives both generally and with
respect to particular outcomes, including FSA, May 2007 Progress Report; and FSA, Treating
Customers Fairly: Measuring Outcomes November 2007 (2007).
The FSA’s 2008–2009 Major Retail Thematic Work Plan, for example, highlighted the TCF
initiative.
FSA, Measuring Outcomes November 2007, p. 4.
Firms were to be implementing TCF in a substantial part of their business by March
2007. While 93 per cent of major retail firms and 87 per cent of medium-sized investment
firms met this deadline, only 41 per cent of small firms did: Progress Report May 2007,
p. 3. Although the FSA acknowledged that the results were ‘particularly disappointing’ for
smaller firms, they also noted that firms were making slow progress rather than failing to
engage with TCF (p. 5).
Its 2007–2008 Annual Report commended the FSA’s ‘strong’ performance on TCF and the
increased money and energy devoted to communicating the TCF message to small firms:
FSCP, Annual Report 2007–2008, p. 6.
The FSA reported in 2006 that 63 per cent of consumers canvassed were very or fairly
confident that firms were treating customers fairly (Consumer Awareness of the FSA and
Financial Regulation (Consumer Research No. 57, 2006)). By 2007, this had dropped to 54
per cent (Consumer Awareness of the FSA and Financial Regulation (Consumer Research
No. 62, 2007)). Despite challenging market conditions, it had increased to 56 per cent in
2008 (Consumer Research No. 67).
the fairness principle and ‘law in action’
223
effectiveness ‘in action’, is, however, proving troublesome183 as management has struggled to turn a commitment for change into ‘coalface
improvements’.184
Compliance costs can be high, particularly with respect to the gathering of the management information required to evidence TCF. Firms,
notwithstanding the volume of practical guidance, may not be clear on
what the FSA seeks.185 Conversely, by focusing on internal management
processes, and ‘recommending’ increasingly prescriptive procedures, the
TCF initiative carries the risk of increased quasi-prescription of internal
processes. The TCF initiative is also vulnerable to the risks of principlesbased regulation more generally, particularly with respect to enforcement
uncertainties and the accretion of opaque, quasi-regulatory requirements
which are not subject to the disciplines of the law-making process. The
demands it places on supervision, not least in terms of the preparation
of explanatory materials, are considerable, with the TCF initiative generating something of a tidal wave of supporting FSA documentation. But,
while the evidence points to the difficulties in delivering the ambitious
TCF agenda, it also points to the likely even more severe difficulties in
delivering high-quality investment advice on the basis of rules ‘on the
books’.
4. The implications of the TCF model
In practice, the TCF initiative operates in parallel with, but somewhat
independently of, the MiFID regime.186 While it represents an imaginative and pragmatic attempt to inculcate firm responsibility for nominated
outcomes, it is rooted in the UK market and reflects the dominance of
notionally ‘independent’ but commission-based investment advisers, the
popularity of often complex investment products and the legacy of misselling scandals. The TCF initiative also reflects the FSA’s statutory consumer protection and awareness objectives and forms part of a wider retail
matrix, together with the FSA’s financial literacy strategy and Retail Distribution Review. Regulatory learning through CESR may see the wider
application of aspects of the TCF model, particularly if MiFID’s principlesbased approach takes root. But the high levels of resources demanded, its
183
184
186
In November 2007 the FSA reported that it had seen little evidence that firms’ TCF
work was translating into improved outcomes for retail consumers: Measuring Outcomes
November 2007, p. 3.
FSA, Discussion Paper No. 08/3, p. 50. 185 Ibid.
Mason, ‘Principles-Based Regulation – Will It Work?’.
224
investment advice and product distribution
relationship to the UK context and its linkage to the FSA’s principles-based
agenda caution against any direct importation or wider application of the
model.
There are, however, some lessons for MiFID’s fair treatment principle.
The TCF initiative points to the limitations of principles-based ‘law on
the books’ in driving cultural change within firms and to the importance
of robust ‘law in action’ in delivering change on the scale demanded
by MiFID.187 The difficulties faced by the FSA in delivering outcomes
under the TCF model, and the extensive supervisory resources required,
do not augur well for the success of MiFID’s principles-based approach,
unless firms’ systems and supervisory action are robust. And the rigorous
supervision needed may become a casualty of wider events. Although
earlier in 2008 the FSA restated its commitment to TCF, it is hard not
to relate the FSA’s subsequent November 2008 decision to scale back its
resource-intensive review of TCF compliance, to cancel its planned final
December 2008 report on TCF preparation and to fold TCF supervision
instead into the annual supervision cycle for investment firms, to the
resources demanded by the financial crisis which intensified in autumn
2008.188
V. Regulatory technique (2): marketing risks
1. Marketing risks
The marketing of investment services and products is a major concern
for retail policy.189 Intuition suggests that an expansion in the range of
products and services to meet greater investor demand, exacerbated in
the pan-EC context and clear from the explosion in complex structured
products, increases the risk of confusion and of unfair or misleading
advertising.190 Marketing communications typically represent the first
stage in the investment process, carry disproportionate impact and are a
187
188
189
190
Either specific regulatory requirements or more pervasive monitoring appear necessary to
reorient firm culture: Condon, ‘Rethinking Enforcement’, 33.
The Financial Times, for example, reported that ‘the City watchdog is rowing back on
plans to assess comprehensively the performance of retail financial services companies in
“TCF” as it focuses on its responsibilities as a bank supervisor’: J. Hughes, ‘FSA Lowers
the Customer Fairness Bar’, Financial Times, 13 November 2008.
Both BaFIN and the AMF have focused on marketing risks: AMF, Annual Report 2007,
p. 4; and BaFIN, Annual Report 2007, p. 146.
CESR’s 2005 Retail Investor Workshop saw stakeholders call for a ‘high degree of vigilance
in relation to financial promotion’: CESR, Annual Report 2005, p. 37. The FSA has also
managing marketing risks
225
key risk point for vulnerable investors, ill-equipped to decode marketing
strategies and trusting of firm communications.191 The evidence from
behavioural finance suggests that investors are particularly vulnerable to
marketing,192 not least as retail investors, reflecting the availability heuristic, can over-rely on ‘simpler’ marketing disclosures where regulated product disclosures are complex,193 tend to trust firms194 and can over-react to
how marketing frames the investment decision,195 particularly as communications tend to accentuate opportunities rather than risk.196 The risks
can be exacerbated in a cross-border context; the Equitable Life mis-selling
scandal, which affected a number of Member States, highlighted not only
the risk of misleading marketing communications, but also the tendency of
cross-border investors, in particular, to rely on advertising.197 As pressures
for retirement financing increase, marketing risks also increase concerning
the decumulation of assets and the purchase of investment products, particularly where advisers are marketed as having specialist expertise with
retirement issues.198 Current turbulent conditions and investor demand
for safer but potentially higher-cost products also exacerbate marketing
risks.199 The emerging data-set on investor behaviour certainly suggests
considerable levels of concern as to aggressive marketing techniques in
191
192
193
194
195
196
197
198
199
noted the risk of an increase in misleading or unfair marketing practices concerning
complex products: FSA Substitute Products Response, p. 17.
The FSA has warned that financial promotions are invitations to engage in investment
activity and so play an influential role in the purchase decision: FSA, Financial Promotions
and Other Communications (Consultation Paper No. 06/20, 2006), p. 9. Similarly, ‘marketing communications may have a material effect [on the investment decision]. This effect
may outweigh the counterbalancing effect of other information produced at a different
stage of the sales process’: CESR, Technical Advice on Possible Implementing Measures of
Directive 2004/39/EC: 1st Set of Mandates (CESR/05-024c, 2005) (‘1st Mandate Advice’),
p. 45.
La Blanc and Rachlinski, In Praise, p. 22 (with respect to the over-confidence bias).
Delmas Report, p. 26. The FSA has similarly warned of over-reliance on marketing: Financial Risk Outlook 2007, p. 91.
See further ch. 2 and n. 16 above.
D. Langevoort, ‘Towards More Effective Risk Disclosure for Technology Enhanced Investing’ (1997) 75 Washington University Law Quarterly 753, 759.
Ibid.
European Parliament, Committee of Inquiry into the Crisis of the Equitable Life Assurance
Society, Report on the Crisis of the Equitable Life Assurance Society (A6-0203/2007, 2007),
pp. 255–7.
Senior Investors, pp. 12–13.
The FSA has highlighted financial promotions in its 2009–2010 Business Plan and is
concerned to raise standards of advertising in what are challenging market conditions:
FSA, Business Plan 2009–2010, p. 26.
226
investment advice and product distribution
the EC.200 More positively, the regulation of marketing communications
may reap dividends as communications may support investor learning
and better decision-making.201
The EC marketing regime, which is now extensive, has three dimensions: the discrete rules which apply to distance and online contracts;
generic consumer protection marketing rules; and MiFID’s rules governing the marketing of MiFID-scope products and services, all with different
regulatory designs.
2. Delivery-specific protection: online and distance contacts
The Distance Marketing of Financial Services Directive (DMD) represented the EC’s first serious foray into the distribution process and marketing risks.202 Although it has been overtaken by MiFID, it remains a
core investor protection measure, particularly for non-MiFID services
and products.203 It addresses the risks posed to investors204 in the context
of distance marketing of financial (including investment) services.205 In
this context, investors’ informational disadvantages and monitoring difficulties may be deepened given the lack of personal interaction206 and
they may be unable to assess the product or service and the rights and
200
201
202
203
204
205
206
European Commission, Special Eurobarometer No. 230, Public Opinion in Europe on Financial Services: Summary (2005), p. 17, reporting that 35 per cent of respondents (38 per
cent in the EU-15) agreed that the marketing techniques of financial institutions were
aggressive.
High-quality marketing communications have been associated with investor education,
better decision-making, and the countering of information asymmetries: FSA, Consultation Paper No. 06/20, p. 9.
See generally N. Moloney, EC Securities Regulation (2nd edn, Oxford: Oxford University
Press, 2008), pp. 571–86.
Review of the Directive (required under Art. 20) is a key element of the Commission’s
consumer protection agenda and has generated a series of SANCO-commissioned reports
including U. Reifner et al., Final Report: Part I: General Analysis: Impact of Directive
2002/65/EC (2008) and Civic Consulting, Analysis of the Economic Impact of Directive
2002/65/EC (2008).
The Directive applies to the ‘consumer’ (any natural person who, in distance contracts
covered by the Directive, is acting for purposes outside his business, trade or profession:
Art. 2(d)).
Arts. 2(a) and (e).
FIN-USE, Response to the Green Paper on Financial Services Policy (2005–2010), pp. 10–
11. On the other hand, investors tend to over-rely on face-to-face communications: R.
Shiller, Irrational Exuberance (Princeton and Oxford: Princeton University Press, 2000),
pp. 154–62.
managing marketing risks
227
obligations involved. Reflecting the empowerment model, the DMD is
heavily based on investor-facing disclosure requirements (chapter 5). But,
by providing a mandatory fourteen-day withdrawal right,207 it also takes
a more interventionist approach to investor protection and reflects some
degree of paternalism.208 This protection is, however, of limited relevance,
as it does not apply where the price of a product or service reflects market
fluctuations which may occur during the withdrawal period,209 although
the withdrawal right does apply to contracts to receive investment advice
or portfolio management services. Cold-calling, however, is addressed
only tangentially by the Directive (section V.4.b below).
Ancillary protections are also available under the E-Commerce
Directive210 concerning online services, largely with respect to disclosure, but online commercial communications211 are also subject to clarity requirements,212 while unsolicited communications follow the DMD
model for cold calls (section V.4.b below) and are, in essence, permitted.213
The E-Commerce Directive also engages with contractual requirements
and introduces rules on the conclusion of contracts by electronic means
which are designed to ensure that contracts concluded by e-commerce are
electronically workable.214
3. Horizontal protection: consumer protection directives
Retail investors are also protected by the horizontal, consumer protection directives which address marketing, chief among them from the
207
208
209
210
211
212
Arts. 6 and 7. Withdrawal rights have also been granted in respect of life assurance products
in Directive 2002/83/EC of the European Parliament and Council of 5 November 2002
concerning life assurance, OJ 2002 No. L345/1, Art. 35.
C. Camerer, S. Issacharoff, G. Loewenstein, T. O’Donoghue and M. Rabin, ‘Regulation for
Conservatives: Behavioral Economics and the Case for Asymmetric Paternalism’ (2002–3)
151 University of Pennsylvania Law Review 1211, 1240 and 1243.
These include services relating to: foreign exchange; money-market instruments; transferable securities; units in CISs; financial futures contracts; forward interest rate agreements;
interest rate, currency, and equity swaps; and options to acquire any of these instruments,
including equivalent cash-settled instruments. The Delmas Report, however, called for a
discrete two-day cooling-off period to be granted to UCITS investors.
Directive 2000/31/EC of the European Parliament and of the Council of 8 June 2000 on
certain legal aspects of information society services, in particular electronic commerce, in
the internal market, OJ 2000 No. L178/1.
Any form of communication designed to promote, directly or indirectly, the goods, services
or image of the provider (Art. 2(f)).
Art. 6. 213 Art. 7. 214 Arts. 9–11.
228
investment advice and product distribution
retail investor perspective the 2005 Unfair Commercial Practices (UCP)
Directive.
The Directive,215 which has its roots in EC consumer law and policy,216
represents a significant addition to the arsenal available to the retail
investor. Like the DMD, its protections apply to ‘consumers’.217 It adopts
a considerably more interventionist approach than MiFID which, for the
most part, does not prohibit particular forms of marketing but relies
heavily on firm compliance with the over-arching requirement that communications are ‘fair, clear and not misleading’;218 the UCP, by contrast,
prohibits certain types of marketing outright.
It applies to ‘unfair’ business-to-consumer commercial practices,
before, during and after a commercial transaction in relation to a product (Article 3(1)). The wide and generic definitions of business-toconsumer commercial practices (Article 2(d)) and products (Article 2(c))
bring investment services within the Directive’s scope, although commercial practices which are not directly designed to influence transactional decisions,219 such as annual reports and corporate promotional
literature, are excluded (recital 7). The risks posed by the misleading
marketing of financial products are expressly addressed by recital 10,
which highlights the Directive’s importance for complex products with a
high level of risk to consumers, and particularly financial services products, where a trader seeks to create a false impression of the product’s
nature.
‘Unfair’ commercial practices are prohibited (Article 5), although a
reasonableness regime applies. A practice is ‘unfair’ if, reflecting notions
of reasonableness, it is contrary to the requirements of professional
215
216
217
218
219
B. De Groote and K. De Vulder, ‘European Framework for Unfair Commercial Practices: Analysis of Directive 2005/29’ (2007) Journal of Business Law 16; and S. Weatherill
and U. Bernitz (eds.), The Regulation of Unfair Commercial Practices under EC Directive 2005/29/EC: New Rules and Techniques (Oxford and Portland, OR: Hart Publishing,
2007).
European Commission, Green Paper on EU Consumer Protection (COM (2001) 531),
pp. 11–15.
Any natural person who, in commercial practices covered by the Directive, is acting for
purposes outside his trade, business, craft or profession (Art. 2).
Conflicting provisions in specific sectoral directives take precedence (Art. 3(4)), but
MiFID’s prohibitions on particular forms of marketing communication are very limited.
Any decision taken by a consumer concerning whether, how, and on what terms to
purchase, make payment in whole or in part for, retail or dispose of a product or to
exercise a contractual right in relation to the product, whether the consumer decides
to act or to refrain from acting: Art. 2(k).
managing marketing risks
229
diligence220 and materially distorts,221 or is likely to materially distort, the
economic behaviour with regard to the product of the ‘average consumer’
whom it reaches or to whom it is addressed (or the average member of the
group where the practice is directed to a particular group of consumers).
Reasonableness is further supported by the robust approach taken to the
competent and informed ‘average consumer’.222 A commercial practice is
characterized as ‘unfair’ and so prohibited where it is ‘misleading’, within
the terms of Articles 6 and 7, or ‘aggressive’,223 within the terms of Articles
8 and 9. ‘Misleading’ practices are those which contain false information
and are untruthful or, in any way, including overall presentation, deceive
or are likely to deceive the average consumer across a number of different
dimensions,224 or are likely to cause the consumer to take a transactional
decision which would not otherwise have been taken (Article 6). Of particular relevance to the investor protection context is the determination
that practices can be misleading where material information (including
required investment-related disclosures)225 is omitted which the average
consumer, according to the context, needs in order to take an informed
transactional decision, and the omission causes, or is likely to cause, the
average consumer to take a transactional decision that would not otherwise have been taken (Article 7(1)). This provision, and the consequent
220
221
222
223
224
225
Which relates to the standard of special skill and care which a trader may reasonably
be expected to exercise towards consumers, commensurate with honest market practices
and/or the general principle of good faith in the trader’s field of activity.
Behaviour is materially distorted where the practice appreciably impairs the consumer’s
ability to make an informed decision, causing the consumer to take a transaction decision
that would not otherwise have been taken (Art. 2(e)).
The ‘average consumer’ concept is based on the European Court’s consumer law jurisprudence and assumes a consumer ‘who is reasonably well-informed and reasonably observant
and circumspect, taking into account social, cultural and linguistic factors’: recital 18 (see
further ch. 2).
Aggressive practices are of less direct relevance to the investor protection context; a practice
is aggressive if by harassment, coercion or undue influence it significantly impairs or is
likely to significantly impair the average consumer’s freedom of choice or conduct with
regard to the product and causes the consumer to take a transactional decision which
would not otherwise have been taken (Article 8).
These are listed in Art. 6(1) and include the existence or nature of the product, its main
characteristics, the extent of the trader’s commitments, the motives for the practice and
the nature of the sales process, the price and the nature, attributes and rights of the trader,
including qualifications.
Art. 7(4) lists information which is to be regarded as material, including the main characteristics of the product, the price, and withdrawal rights, where they apply. MiFID’s
disclosure requirements are also regarded as material under Art. 7(5).
230
investment advice and product distribution
prohibition of the related commercial practice or marketing communication and the prospect of enforcement action,226 dovetails with MiFID’s
imposition of positive disclosure requirements on the investment firm. Of
similar importance is the determination that a practice is misleading where
a trader hides material information or provides material information in an
unclear, unintelligible, ambiguous or untimely manner, or fails to identify
the commercial intent of the practice and where, in either case, this causes,
or is likely to cause, the average consumer to take a transactional decision
which would not otherwise have been taken (Article 7(2)). This requirement chimes well with MiFID’s over-arching requirement that disclosure
be ‘fair, clear and not misleading’ (Article 19(2)) and ‘comprehensible’
(Article 19(3)). It also imposes discipline on UCITS product providers
with respect to UCITS marketing.
The Directive’s key concepts are challenging from a legal certainty perspective, certainly by comparison with the process-based suitability protections which characterize MiFID, and even by comparison with the
‘fair, clear and not misleading’ concept which governs MiFID’s marketing
regime and the over-arching Article 19(1) fair treatment principle. In an
attempt to provide legal certainty, the ‘misleading’ and ‘aggressive’ regime
is supplemented by Annex I to the Directive which sets out a ‘blacklist’
of commercial practices which, in all circumstances, are to be regarded as
unfair.227
On the continuum of retail market measures from empowermentdriven and disclosure-based measures to interventionist and protective
measures which direct firm behaviour, the Directive has a distinctly paternalistic and interventionist feel; despite the risks of the consumerist agenda
for investor protection policy,228 where investor protection derives from
consumer protection measures, EC protections can, at times, become considerably more interventionist and less reliant on disclosure. On the other
hand, there are synergies between the Directive and investor protection
226
227
228
The Directive requires that penalties be effective, proportionate and dissuasive (Art. 13)
and that actions for injunctions can be brought by persons and organizations with a
legitimate interest in combating unfair commercial practices (Art. 11).
These are the only practices which can be deemed ‘unfair’ without a case-by-case assessment against Arts. 5–9 (recital 17). Practices of particular importance to the retail investor
include: falsely claiming to be a signatory to a code of conduct; falsely claiming that a
code of conduct has an endorsement from a public or other body; falsely claiming that a
trader or product has been approved, endorsed or authorized by a public or private body;
and stating or otherwise creating the impression that a product can be legally sold when
it cannot.
Chs. 1 and 2.
managing marketing risks
231
regulation and policy; the tension in investor protection policy between
the empowered and the vulnerable investor is reflected in the Directive’s
linkage of what is ‘unfair’ to the ability of what seems to be a robust average
consumer to make an informed decision.
4. Investment-specific protection: MiFID
a) Marketing communications
Retail investor protection against marketing risk is largely a function of
MiFID’s specialized rules. Article 19(2) addresses marketing risks through
an over-arching, conduct-shaping rule which requires that all information, including marketing communications, which is addressed by a firm
to (potential) clients must be ‘fair, clear and not misleading’ – a formula
which will be clarified through supervisory action, industry practice and,
potentially, litigation. It governs all communications between the firm and
the investor, and so is central to the disclosure regime, but has particular
significance for marketing communications. Article 19(2) is amplified by
the related level 2 regime (MiFID Level 2 Directive, Article 27) which is
expressly targeted to retail investors. The regime does not require preapproval of marketing communications or prescribe their content; it is
designed to be principles-based, facilitative, and to allow firms flexibility
in designing their marketing disclosure and accordingly sets out the general conditions with which information must comply in order to be ‘fair,
clear and not misleading’.229 The regime’s main concern is with requiring
key disclosures and risk warnings rather than with prohibiting or prescribing particular forms of disclosure. The undercutting ‘fair, clear and
not misleading’ obligation is tightened, however, in that it is not couched
in ‘take reasonable steps’ terms, but is absolute.
Much of the regime reflects traditional approaches to protecting
investors from marketing. So marketing communications must be accurate and must not emphasize the potential benefits of an investment
without also giving a fair and prominent indication of risk, and communications must not disguise, diminish or obscure important items,
statements or warnings (Article 27(2)). Particular requirements apply to a
range of marketing techniques which are prone to investor over-reaction,
229
‘After some consideration’, the Commission decided not to prescribe the content or characteristics of marketing communications but to base the regime on guiding principles as
to whether a communication was ‘fair, clear and not misleading’: July 2005 Explanatory
Note, p. 2.
232
investment advice and product distribution
such as suggestions of endorsement by a regulatory authority (prohibited under Article 27(8)), tax information (a warning must be provided that tax treatment depends on individual investor circumstances)
(Article 27(7)), simulated historic returns (Article 27(5)), past performance disclosure (Article 27(4)), comparisons (Article 27(3)) and projections (Article 27(6)).230 But, by adopting an essentially facilitative
approach, the regime also reflects a generally robust approach to investor
competence by, for example, permitting simulated returns231 and past performance disclosures.232 Investors are particularly vulnerable to marketing communications in the form of direct offers and non-advised offers of
investment products, as became clear in the UK following the split-capital
investment trust scandal. Direct offers are expressly addressed by Article
29(8) which imposes specific disclosure requirements. But disclosure is an
unreliable method for dealing with retail investor risks, particularly given
the range of complex products which may be sold through these executiononly channels and the related failures in the investment product market,
outlined in chapter 3.
A notable innovation, however, concerns the requirement that marketing communications be appropriately targeted; an innovation which
would be well applied to product design.233 Firms must ensure that information is presented in such a way that it is likely to be understood by
the ‘average member’ of the group addressed (Article 27(2)). While this is
a challenging requirement given the different capabilities of investors,234
it is an innovative attempt to steer the marketing of complex and risky
products away from vulnerable investors and to embed the production of
‘fair, clear and not misleading disclosure’ within the firm.
b) Cold calls and boiler rooms
Retail investors are likely to be most vulnerable with respect to cold calls,
particularly where the calls relate to ‘boiler room’ frauds which seek to
sell worthless shares to vulnerable investors.235 Unusually given investor
vulnerability in this context, but reflecting the DMD which only curtails
230
231
232
234
235
See further ch. 5.
CESR, by contrast, prohibited simulated historic returns: 1st Mandate Advice, p. 47.
See further ch. 5. 233 See further ch. 3.
Although the FSA has suggested that a ‘common sense’ approach be adopted and that
arithmetical calculations are not required of firms: Consultation Paper No. 06/20, p. 14.
The Australian conduct regulator (ASIC) reported that approximately €509 million
was lost to cold-calling and other financial scams between 2001 and 2003: reported
in OECD, Examining Consumer Policy: A Report on Consumer Information Campaigns
Concerning Scams (OECD, 2005). Significant losses have also been sustained in the UK,
managing marketing risks
233
the use of automatic-calling machines and fax machines236 and does not
prohibit cold calls,237 MiFID does not directly address cold calls. In one
of the few examples of an area of significant importance to the retail
markets which falls outside the EC regime, the treatment of cold calls
remains with the Member States;238 the Alpine Investments ruling suggests that the European Court of Justice will be sympathetic to Member
State rules in this area even where they pose an obstacle to the Treaty
freedoms.239
Where the calls are made by MiFID-scope firms, they are, however,
subject to the general fair treatment obligation and to the Article 19(2)
requirement that any information communicated during a call be fair, clear
and not misleading. The UCP Directive also characterizes ‘persistent and
unwanted solicitation’ by phone, email and fax as ‘unfair’ in the annex
blacklist (and so prohibited), although this is without prejudice to the
DMD regime.240 But investors are typically most vulnerable to cold calls
from overseas ‘boiler rooms’ which are usually beyond the reach of EC
regulation and national enforcement, leading to the FSA’s efforts in this
area241 being focused in part on building international co-operation in
addressing boiler room frauds.242 The treatment of cold calls is therefore
perhaps best regarded as a function of investor education,243 and not of
regulation alone.
236
237
238
239
240
241
242
243
with the FSA reporting in 2008 that around 30,000 people became victims of boiler
room frauds, representing losses of £300 million: FSA, Press Release, 10 November 2008
(FSA/PN/128/2008). BaFIN has also recently engaged in an audit of cold calls: Annual
Report 2007, p. 145. The FSA has also highlighted the greater vulnerability of older people
to share scams and adopted a targeted awareness campaign: FSA, Press Release, 27 April
2009 (FSA/PN/055/2009).
Art. 10(1) requires the consumer’s prior consent before the use of automatic-calling
machines and fax machines is permitted.
Art. 10(2) appears to leave the issue of prior consent to the discretion of the Member
States under an opt-in/opt-out model.
Cold calls are prohibited in the UK unless there is an existing client relationship and the
call relates to nominated lower risk investments (readily realizable securities and generally
marketable, non-geared packaged products): COBS 4.82.
Alpine Investments v. Minister van Financi¨en [1995] ECR I-1141 (Case C-384/93).
Annex I, para. 26.
Which include a successful application to wind up a UK partnership which facilitated
offshore boiler-room share sales: J. Gray, ‘At FSA’s Application High Court Orders Winding
up of UK Partnership Which Facilitated Offshore Boiler Room Share Sales to UK Investors’
(2007) 15 Journal of Financial Regulation and Compliance 343.
FSA, Press Release, 10 November 2008 (FSA/PN/128/2008).
The FSA has issued an education leaflet on the dangers of boiler rooms, pointing to the
non-application of UK (and EC) law: FSA, Share Investment Scams (2004).
234
investment advice and product distribution
c) An effective regime?
Notwithstanding its facilitative approach, the MiFID marketing regime is
designed to address vulnerable and trusting investors. But it avoids overt
paternalism, and the related risks of over-prescription and ‘tick-the-box’
compliance, which the UK experience points to,244 by focusing on core
principles and the treatment of specific disclosures which are vulnerable to
over-reaction, rather than on prescribing content and requiring ‘laundrylists’ of risk warnings which are of limited use to investors.245 Lengthy
catalogues of risks may only generate investor resistance and overload,
lead to poor engagement with warnings246 and obscure key messages.
The over-arching Article 19(1) fair treatment obligation and the
Article 19(2) ‘fair, clear and not misleading’ obligation, together with
the novel requirement that firms consider the ‘average investor’ targeted
by the communication, form a regime which requires investment firms
to consider the overall fairness and clarity of communications ‘in action’.
Combined with the Article 4 prohibition on gold-plating, it has the potential to give firms flexibility in designing marketing, drive cultural change
within firms and closer communication between compliance and marketing departments and, ultimately, support more informed decisionmaking by investors with well-designed communications. It also has the
potential, at least, to capture the different risks raised by the expanding universe of investment products, including structured products.
MiFID’s marketing regime certainly seems to have some catalytic potential. Although the FSA was already committed to its ‘more-principlesbased’ regulation agenda, MiFID implementation and the Article 4 goldplating prohibition were key drivers in its Financial Promotions Review
of the previously detailed financial promotions regime and the adoption of a principles-based approach;247 by contrast with the pre-MiFID
244
245
246
247
The pre-MiFID detailed regulation of marketing communications in the UK has been
associated with ‘tick-the-box’ compliance, particularly with respect to risk warnings, and
failures to make promotions fair, clear and not misleading: T. Katz (FSA), Speech on
‘Financial Promotions and More Principles-Based Regulation – Freedom and Responsibility’, 28 November 2007, available via www.fsa.gov.uk/Pages/Library/Communications/
Speeches/index.shtml.
One FSA study has reported that investors feel too much is expected of them by financial
marketing and that small print disclosures and risk warnings are of limited value: FSA,
Report of the Task Force on Past Performance (2001), p. 10.
FSA research on the reaction by investors to the scripted questions used to test the Basic
Advice regime for stakeholder products found a low recall of warnings, particularly where
multiple warnings were given: FSA, A Basic Advice Regime for the Sale of Stakeholder
Products (Consultation Paper No. 04/11, 2004), p. 12.
Although the FSA was already committed to reforming its prescriptive and product-specific
financial promotions regime under the Financial Promotions Review, and to substantially
quality of advice and suitability
235
regime,248 the FSA’s rulebook249 no longer prescribes specific rules for
particular investments and products but relies on firm judgment in the
application of the high-level MiFID rules.250
But, while the new regime’s design appears reasonable, its effectiveness
will depend on how competent authorities police the new regime and
support firms in its application. Poor compliance with marketing requirements has emerged in the UK, where the FSA has identified marketing as a
key supervisory and enforcement priority given persistent weaknesses,251
and elsewhere,252 and strenuous supervision is likely to be required.253
VI. Regulatory technique (3): quality of advice and suitability
1. Suitability and objective advice
Although the MiFID distribution and advice regime is composed of several
interlocking elements, the current policy focus is largely on the quality
and objectivity of advice and, accordingly, on rules to address commission
248
249
250
251
252
253
reducing its prescriptive rules, MiFID was a key driver: Consultation Paper No. 06/20,
pp. 7–8.
Pre-MiFID, detailed and often product-specific rules applied which governed when promotions were ‘fair, clear and not misleading’. The new principles-based regime is designed
to address the risks that detailed rules can divert firm attention from the purposes of
regulation, that product-related requirements can be inflexible and that extensive rules
can act as a barrier to entry for small firms, and to encourage greater senior management
responsibility and allow firms greater freedom: ibid., p. 7.
The new MiFID regime is set out in COBS 4.
Consultation Paper No. 06/20, pp. 15–16. The new approach is asserted to deliver ‘real
benefits’ for firms and consumers in the form of greater flexibility for firms and in the
form of financial promotions which are tailored more closely to the needs of consumers:
p. 3.
The 2007–2008 Retail Market Thematic Plan highlighted the FSA’s focus on financial
promotions and its concern that one-quarter of promotions were difficult to navigate:
FSA, Major Retail Thematic Work Plan for 2008–2009, p. 7. The FSCP has also identified
marketing communications as a key vulnerability for investors given the potential for
consumer detriment where communications are unclear and unbalanced, the contagion
risks which arise where a firm pushes at the boundaries of what it is acceptable and is
followed by other firms and lack of understanding of the new MiFID regime: FSCP, Annual
Report 2007–2008, p. 23.
E.g. AFM, Annual Report 2006, p. 53.
The FSA’s experience is not encouraging. The FSCP, which was hostile to the adoption
of a principles-based approach to marketing communications (Annual Report 2007–2008,
p. 38), has expressed concern as to the FSA’s track record on enforcement of marketing requirements, rating the FSA’s performance on financial promotions as ‘weak’ and
criticizing it for concentrating only on major rule breaches (Annual Report 2006–2007,
p. 6), although its 2007–8 Annual Report reported more proactive and themed monitoring
(p. 23).
236
investment advice and product distribution
risk (section X below) and on process-based rules to ensure that advice
and products are ‘suitable’ for the investor. Traditionally, suitability rules
have been associated with a paternalistic approach to the retail investor254
and thus the trusting rather than empowered investor. More recently,
they have been associated with minimizing the behavioural defects under
which investors operate.255 Increasingly, they are regarded, in tandem with
conflict-of-interest and commission risk rules, as a key mitigant for misselling risks in the mass retail market,256 particularly in the sale of complex
and alternative investments,257 and as of central importance in protecting
and empowering retail investors.
Suitability rules carry a number of potential benefits. Unlike the Article
19(1) fairness obligation, which implies some form of troublesome value
judgment, and the related reliance on fairness and ‘not misleading’ standards for marketing, suitability requirements, while ultimately based on
adviser judgment, are process-based. They do not prescribe a particular
outcome. But they do require that an adviser ‘knows the client’258 and
makes a personalized recommendation which reflects the investor’s needs
and profile. Together, conflict-of-interest and suitability-based quality-ofadvice rules can also dilute the risks of failures in product regulation and
mitigate the limitations of disclosure. Suitability requirements can also
support wider investor access to riskier products, and engage with market
risk, by allowing regulatory regimes to support retail investor access to
products which might otherwise be restricted through public marketing
restrictions by placing firms under an obligation to assess an investment’s
suitability.
Although there were traces of suitability in the earlier Insurance
Mediation Directive,259 MiFID’s introduction of suitability requirements
brought major change to the EC’s investor protection regime. Suitability requirements have, however, long been a staple of the UK regime,
with suitability one of the FSA’s High Level Principles for Business.260
254
255
256
257
258
259
J. Markham, ‘Protecting the Institutional Investor – Jungle Predator or Shorn Lamb’
(1995) 12 Yale Journal of Regulation 345.
L. Cunningham, ‘Behavioral Finance and Investor Governance’ (2002) 59 Washington &
Lee Law Review 767, 798–9.
Joint Forum Report, p. 6.
European Parliament, Resolution on Asset Management (P6 TA-PROV(2007)0627, 2007)
(‘Klinz II Resolution’), noting the importance of MiFID’s suitability and appropriateness
rules as protections against mis-selling: para. 41.
D. Smith and S. Legett, ‘Client Classification’ in Skinner, The Future of Investing, p. 65,
p. 72.
See sect. XI below. 260 Principle 9.
quality of advice and suitability
237
The MiFID regime, which the FSA regarded as reinforcing existing standards of good market practice,261 has now been ‘copied out’ into the FSA
rulebook.262 But, even here, MiFID has required changes, particularly in
the form of the new MiFID ‘appropriateness’ regime (which allows for
a lighter-touch suitability test in certain circumstances),263 the removal
of the requirement that advisers recommend the ‘most suitable’ product
from the range on which they advise,264 and restrictions on the extent
to which the UK regime can experiment with suitability models. As discussed in section XII below, the costs of suitability, and the related impact
on access to advice, led to the adoption of the Basic Advice regime, which
follows a lighter suitability process based on pre-scripted questions265 –
but it can apply only to non-MiFID firms.
2. The suitability regime: suitability and appropriateness
The suitability assessment required under Article 19 takes two forms: (1)
the assessment of ‘suitability’ (Article 19(4)) and (2) the assessment of
‘appropriateness’ (Article 19(5)), depending in each case on the degree
of investor reliance on the adviser. In a clear expression of support for
investor choice and competence, and in an example of how empowerment
and protection can be blended, execution-only services in ‘non-complex
products’ are not subject to suitability requirements.266 The centrality of
investor choice to the regime has been recognized by CESR’s MiFID Guide
for Retail Investors, which emphasizes the importance of the investor’s
decision as to the degree of reliance on advice in driving the level of
protection provided.267
Under Article 19(4), where the firm provides investment advice or
portfolio management services, a suitability assessment is required. The
process-based regime allows firms a significant degree of flexibility;
261
262
263
264
265
267
FSA, Consultation Paper No. 06/19, p. 77.
COBS 9 (suitability) and 10 (appropriateness).
The FSA has made some efforts to explain the nature of the new and unfamiliar test
(FSA, The New Appropriateness Test – A New Requirement (2007)) and industry guidance
has been adopted (MiFID Connect, Guidance on the Application of the Suitability and
Appropriateness Requirements under the FSA Rules Implementing MiFID in the UK (2007)).
Additional and detailed guidance to the copied-out COBS appropriateness obligation is
also set out in COBS 10.
Consultation Paper No. 06/19, p. 77; and FSA, Policy Statement No. 07/6, p. 49.
COBS 9.6.3 and 9.6.6. 266 See further chs. 2 and 6.
CESR, A Consumer’s Guide to MiFID: Investing in Financial Products (CESR/08-003, 2008),
p. 6.
238
investment advice and product distribution
the process is calibrated to the nature of the investor, the service and
the investment.268 This flexibility also allows the suitability assessment to
apply to the range of choices which may be made by the firm; it captures, for
example, any decision by the firm to choose a particular platform on which
to manage an investor’s portfolio.269 It may also, as the FSA has assumed
in its Retail Distribution Review, support access to advice by allowing
firms to develop cheaper ‘advised-sales’ processes which are based on a
more limited suitability assessment but within MiFID’s requirements.270
The firm must obtain the ‘necessary information’ regarding the investor’s
knowledge and experience in the investment field, which must be relevant
to the specific type of product or service, and regarding the investor’s
financial situation and investment objectives,271 so as to enable the firm to
recommend the investment services and financial instruments ‘suitable’
for the investor.272 Where the ‘necessary information’ is not provided, the
regulatory response is paternalistic; the investment firm must not recommend investment services or instruments (MiFID Level 2 Directive, Article
35(5)).273 A firm can, however, proceed with a particular transaction on
a non-advised basis, under the execution-only regime, as long as the conditions of that regime and the Article 19(1) fair treatment principle are
met; the same strategy could be adopted where a firm determines that a
transaction is unsuitable for the investor. Although the suitability regime
268
269
270
271
272
273
Level 2 Directive, Arts. 35 and 37.
The FSA has identified suitability rules as a key technique for managing risks to investors
where platforms and wraps are used: Discussion Paper No. 07/2, pp. 24 and 29–30.
2008 RDR Feedback Statement, p. 63.
The information which must be collected concerning the investor’s financial situation
includes, where relevant, information on the investor’s source and extent of regular income,
assets, investments and real property, and regular financial commitments (Art. 35(3)),
while the information with respect to investment objectives covers the investor’s time
horizon, risk-taking preferences, risk profile, and the purposes of the investment (Art.
35(4)). Information related to knowledge and experience includes the level of education
and the profession or former profession of the investor (Art. 37).
MiFID, Art. 19(4). The firm must obtain such information as is necessary for it to understand the ‘essential facts’ about the client, and for the firm to have a ‘reasonable basis for
believing’, given due consideration of the nature and extent of the service provided, that the
transaction satisfies three suitability criteria: it meets the client’s investment objectives; the
client is able financially to bear the related investment risks consistent with his investment
objectives; and the client has the necessary experience and knowledge to understand the
risks involved in the transaction or in the management of the portfolio (MiFID Level 2
Directive. Art. 35).
Although the FSA is of the view that MiFID offers ‘inherent flexibility’ as to what ‘necessary
information’ includes, and that it can be calibrated according to the type of client and the
nature of the service: Consultation Paper No. 06/19, p. 80.
quality of advice and suitability
239
therefore has a paternalistic tinge, it allows for a degree of flexibility and
investor autonomy.
A lighter touch ‘appropriateness’ regime (Article 19(5)) applies where
services ‘other than Article 19(4)’ services are provided.274 These ‘nonadvised’ services275 include in particular execution-only transactions in
complex products.276 Investor choice, and support of the empowered
investor, lies behind this classification: ‘the impetus behind a light touch
sales regime is to simplify current sales practices, to reduce costs to the
consumer and to encourage them to make active choices about the products or services offered’.277 Implicit in the regime is that the transaction is
investor-led rather than adviser-led.278 The assessment requires the firm
to ask the investor to provide information only regarding the investor’s
knowledge and experience in the investment field279 relevant to the specific type of product or service demanded, so as to enable the firm to assess
whether the service or product is ‘appropriate’; the firm must simply assess
whether the client has the necessary experience and knowledge in order
to understand the risks involved in relation to the specific type of product
or service offered or demanded.280 Article 19(5) also appears to support
low-cost, online assessments of appropriateness.281 By contrast with the
suitability regime, an assessment is not required of the client’s financial
situation or investment objectives and, in practice, the focus is on whether
the investor is an appropriate client to be offered the product or service282 –
such as execution-only access to complex products. Also by contrast with
274
275
276
277
278
281
282
Its exact scope caused some confusion, with market participants asking CESR for clarification on when the regime applied, which CESR did not supply (as to do so would have been
outside the level 2 mandate): CESR, Technical Advice on Possible Implementing Measures
of Directive 2004/39/EC: 1st Set of Mandates where the Deadline Was Extended and 2nd Set
of Mandates: Feedback Statement (CESR/05-291b, 2005), p. 25.
The FSA has described the appropriateness regime as aiming to increase investor protection
in the non-advised market: FSA, Appropriateness, p. 1.
CESR has linked ‘appropriateness’ to execution-only services in complex products: MiFID
Consumer Guide, p. 7.
Economic and Monetary Affairs Committee, A5-0114/2004, 2004, amendment 19.
Ibid. 279 Specified in Art. 37. 280 MiFID Level 2 Directive, Art. 36.
The FSA has suggested that the assessment could occur online through electronic application forms which automatically process clients’ answers to targeted questions: Appropriateness, p. 6.
Clifford Chance, The Future in the UK for Retail Structured Products, Client Briefing
(2007), p. 2. The FSA has interpreted the test as, in certain cases, requiring little more than
establishing or confirming that the client is a sufficiently experienced investor in the type
of product, although it has warned that the assessment should be particularly rigorous
where more complex products are offered to less experienced clients: FSA, Appropriateness,
p. 6.
240
investment advice and product distribution
the suitability regime, investor failure to supply the information does not
prevent the firm from supplying the service, as long as a risk warning is
provided; greater investor autonomy and capacity is assumed. Similarly,
where the firm finds that a product or service is not appropriate for the
investor, the firm must warn the client but is not prevented from supplying
the product or service, but due regard should be given to the Article 19(1)
fair treatment obligation.
The suitability regime reflects the reality of reliance by trusting investors
on advisers. But it also reflects the empowerment and engagement movement in that it accommodates considerable investor autonomy and freedom to choose lower cost services. Whether or not engaged but vulnerable
investors who heavily rely on advice are sufficiently supported, however,
depends on the effectiveness of the regime ‘in action’.
3. Suitability ‘in action’
The advent of a new suitability regime ‘on the books’ might promise much
for better quality advice, including stronger diversification-based protection against market risks, not least given some pre-MiFID evidence of
poor practices.283 But the delivery of an effective suitability regime, and
support of high-quality and objective advice, requires strategies beyond
regulation. The quality of advice depends on a range of factors which are
very difficult to support through regulatory fiat, including the impartiality
of advisers (section X below), and which can disable the suitability assessment. It also depends on the extent to which process-based regulation can
support the exercise of judgment; this is likely to represent a very considerable challenge, not least given herding dynamics, given that rules alone
cannot dictate the quality of advice.284 The ‘credit crunch’, for example, has
revealed concern as to adviser reliance on ratings in assessing the suitability
of structured products.285 But it is highly questionable whether it is realistic
to assume that the competence and conflict-of-interest risks to which rating agencies appear to have been prone, and which were not predicted
ex ante, can be captured by suitability standards, particularly where
283
284
285
C. Jansen, R. Fischer and A. Hackenthal, The Influence of Financial Advice on the Asset
Allocation of Individual Investors (2008), ssrn abstractid=1102092 (based on a German
retail bank data-set).
J. Black, Rules and Regulators (Oxford: Oxford University Press, 1997), pp. 176 and 180.
CESR, Lehman Default, p. 3.
quality of advice and suitability
241
industry-wide herding dynamics arise. Suitability, while process-based,
is also personalized and context-specific; the line between suitable and
unsuitable advice is likely to be a difficult one to draw.286 Laws on the
books are unlikely, of themselves, to achieve stronger quality of advice
outcomes.
MiFID’s suitability standards have been supported in the UK regime
by extensive TCF standards.287 By comparison with MiFID’s broad-brush
requirements, the TCF model imposes very considerable practical prescriptions on the advice process. The FSA’s TCF Factsheet on quality of
advice, for example, considers how firms should consider the quality of
advice with respect to the knowledge and skills of advisers, the assessment
of client needs, recommendations, client communications, corporate culture and good practice,288 and intervenes in some detail in internal management processes. The FSA has also provided two detailed case studies
which consider how a firm might engage in a stock-take of its quality
of advice process289 and which bring firms through the advice process
(based on previous mystery shopping exercises).290 Further detail is provided in the FSA’s July 2006 statement on the quality of advice process291
and in MiFID Connect’s extensive and detailed guidance, which has been
reviewed by the FSA, on the nature of the suitability and appropriateness
assessments.
This approach is some distance from MiFID’s principles-based
approach and suggests considerable FSA scepticism as to the ability of
suitability rules ‘on the books’ to deliver good quality of advice outcomes.
But, even under this more interventionist model, delivering high-quality
advice through suitability requirements has proved troublesome and has
required strenuous supervisory and monitoring efforts. In 2007, the FSA
found an ‘unacceptable number of weaknesses in firms’ processes around
286
287
288
289
290
291
Langevoort, ‘Behavioral Economics’, 95, describing suitability as ‘indeterminate and fact
specific’.
TCF Outcome 4 states that, where consumers receive advice, the advice must be suitable
and take account of their circumstances (e.g. FSA, Measuring Outcomes November 2007,
p. 17).
FSA, Fact Sheet – Improving the Quality of your Financial Advice Process.
FSA, Quality of Advice – Case Study 1. The range of factors to be considered by firms
include: management oversight; quality of advisers; training and competence; monitoring;
the impartiality of advisers; assessing customer needs; and suitability letters.
FSA, Quality of Advice – Case Study 2.
FSA, Quality of Advice Process in Firms Offering Financial Advice: Conditions for Treating Customers Fairly (2006). Similar detail is set out in FSA, Medium and Small Firms:
Considerations for Treating Customers Fairly.
242
investment advice and product distribution
the giving of advice’.292 Mystery shopping tests have delivered less than
impressive results, with only one-third of recommendations proving to be
suitable.293 The nature of complaints to the Financial Ombudsman Service
also suggests persistent problems, with 63 per cent of new complaints with
respect to investment and pension products related to sales and advice in
2007.294 The FSA has also found a bias towards new investments and that
appropriate consideration was not being given to whether mortgage debt
should be repaid.295
The opportunity may also have been missed to support investor monitoring of the quality of advice. Firms are not required to produce a
suitability letter which outlines the course of action advised and why it
is deemed suitable.296 Notwithstanding the costs of such a requirement
unless it is carefully designed,297 this appears to be a missed opportunity –
particularly given the incentives it may provide for industry compliance.
FSA testing298 suggests a relationship between the quality of advice and a
suitability letter or report,299 although the FSA has also reported considerable difficulties with the quality of suitability letters.300 From the demand
292
293
294
295
296
297
298
299
300
The FSA found ‘limited direct evidence available to satisfy us that consumers are experiencing improvements with quality of advice’: Measuring Outcomes November 2007,
pp. 17–18.
The FSA’s ‘mystery shopping’ tests have suggested that the sales and advice process in
one-third of firms had a negative impact on advice, that a half of firms gave advice before
a relevant or in-depth fact-find, that only one-third could demonstrate a fair sales process
and adequate recommendations, that two-thirds of firms were not able to display a full and
fair recommendation process, and that one-fifth of firms undertook a cursory assessment
of needs and generated a serious risk of detriment: FSA, Consumer Research No. 52, pp. 7,
11 and 14.
FOS, Annual Review 2007–2008, p. 21 (excluding complaints with respect to mortgage
endowment products, where 96 per cent of complaints related to sales and advice).
E.g. FSA, Consumer Research No. 52, p. 9.
Although Member States have the option of requiring one, as the UK and the Netherlands
have done: Joint Forum Report, p. 14.
The requirement for a ‘statement of advice’ under Australia’s Financial Services Reform
generated concerns as to its costs and led to its subsequent refinement: Treasury, Refinements Proposal. Similarly, the major cost of regulation study commissioned by the FSA
(Deloitte, Cost of Regulation (2006)) reported that, with respect to investment advice
business, the FSA’s suitability letter requirement was the most costly rule: p. 52.
The FSA regime requires firms who advise on packaged products to produce a suitability
report (COBS 9.4.1); the report, which allows firms discretion in design and content but
is subject to detailed TCF requirements, is a streamlined version of the earlier and more
prescriptive pre-MiFID suitability letter.
Oxera, Assessment of the Benefits of the Suitability Letter (2007), pp. 37–8. The FSA concluded that removing the requirement could prejudicially affect firms’ behaviour: Policy
Statement No. 07/14, p. 16.
FSA, Investment Quality of Advice Processes II (2008), p. 2.
quality of advice and suitability
243
perspective, the educative possibilities of such a letter and its potential
for empowering investors to take subsequent action, where appropriate,
may be considerable.301 MiFID does, however, impose record-keeping
obligations under Article 19(8) and CESR has suggested that appropriate
records be kept such that compliance with the suitability regime can be
assessed.302
Suitability requirements are also problematic in terms of supervision
and enforcement. While process-based, suitability is based on context,
information, experience, judgment and the nature of the investor, which
all pose considerable ex ante assessment and enforcement difficulties.
Supervisory fact-finds are complex and may require troublesome ex post
benchmarking of advice and a considerable commitment of supervisory
resources and expertise. The difficulties are exacerbated by the limited
ability of investors to assess the quality of advice and to take enforcement
action. Resource-intensive supervision, including mystery shopping, is
required. The evidence of improvements which is emerging from the
FSA experience (by 2008, improvements had occurred in the impartiality
of advice, particularly with respect to non-commission-earning advice on
debt repayment303 ) should be related to the strenuous efforts and resources
exerted by the FSA in monitoring quality of advice progress under the TCF
initiative. Following the poor results from its 2006 review, for example,
the FSA developed tools to support small firms in providing investment
advice.304 Review of the quality of advice was also a priority of the FSA’s
Retail Thematic Work Plan for 2007/2008 and for 2008/2009.305
The most serious risk posed by the suitability regime in terms of
supporting engaged but vulnerable and trusting investors may, however,
derive from an over-emphasis on the suitability of personalized and specific ‘advice’ at the expense of a focus on the conflict-of-interest risks
posed by what are, for most retail investors, ‘sales’ of often proprietary or
commission-based investment products (section X below).
301
302
303
304
305
FSA, Discussion Paper No. 08/5, p. 13 (suggesting that investors should make reasonable
efforts to read, understand and evaluate such letters). The Dutch requirement is based
on supporting investors in understanding the advice given: AFM, Brochure – The Most
Important Amendments to the Supervision of Conduct Following the Introduction of the Act
on Financial Supervision (Wft) (2006).
CESR, Level 3 Recommendation on the List of Minimum Records in Article 51(3) of the
MiFID Implementing Directive (CESR/06-552c, 2007), p. 3.
FSA, Investment Quality of Advice Processes II 2008, p. 10.
FSA, Assessing Customer Needs (2007); and FSA, Communicating with Customers (2007).
FSA, Major Retail Thematic Work Plan for 2008–2009, pp. 3 and 5.
244
investment advice and product distribution
VII. Regulatory technique (4): conflict-of-interest management
1. Conflict-of-interest risks
Conflict-of-interest management within the multi-service investment firm
or bank-based financial supermarket has become a preoccupation of regulators worldwide306 as the nature of investment banking has changed and
the potential for conflicts has increased along with an expanding range of
activities.307 In the retail sphere, corporate finance and securities underwriting can generate risks where poor-quality securities are offloaded to
the retail sector. For a subset of more sophisticated investors, asset management generates particular risks.308 ‘Soft commissions’ and ‘bundling’
arrangements309 – under which services and goods, including research but
also office facilities, computer facilities, databases, training and so on, are
supplied by brokers to asset managers in return for order execution flow –
can generate significant conflicts of interests and raise costs (as the
costs of soft commissions are typically passed on to the investor in
the form of higher dealing fees). Retail investors also face the risk that
portfolios are inappropriately churned to increase portfolio fees and to
increase deal flow to brokers; evidence of high CIS sales over 2005–7
at a time when net purchases of CISs dropped led to concerns that
churning was being resorted to by distributors and independent advisers in an attempt to recoup income.310 Execution quality may also be
poorly monitored and best execution, a central pillar of investor protection in the execution context (chapter 6), may be threatened. Asset
management also generates discrimination risks (in the form of the allocation of more resources and expertise to more sophisticated investors)
and the risk of inappropriate allocation of proprietary products and
own account securities to investor portfolios. The most significant risk
306
307
308
309
310
E.g. ASIC, Managing Conflicts of Interest in the Financial Services Industry (Consultation
Paper No. 73, 2006).
H. Mehran and R. Stulz, The Economics of Conflicts of Interest in Financial Institutions, ssrn
abstractid=943447; and A. Tuch, ‘Investment Banking: Immediate Challenges and Future
Directions’ (2006) 20 Commercial Law Quarterly 37.
M. Kruithof, Conflicts of Interest in Institutional Asset Management: Is the EU Regulatory
Approach Adequate? (2007), ssrn abstractid=871178.
E.g. IOSCO, Soft Commission Arrangements for Collective Investment Schemes (IOSCO,
2007).
Between 2005 and 2007, net purchases of investment funds fell by 94 per cent but gross
fund sales soared by 47 per cent, raising churning risks: S. Johnson, ‘Funds Data Raise
Churning Fears’, Financial Times, Fund Management Supplement, 10 March 2008, p. 21
(reporting on evidence from Lipper Feri of fund sales across thirty leading cross-border
groups).
conflict-of-interest management
245
in the mass retail market, however, remains commission risk, which is
a persistent and apparently intractable risk in the advice and distribution sector (section X below) and which can disable other quality of
advice protections, notably suitability requirements. The development
of new technologies also increases conflict-of-interest risk: the arrival
of platforms and wraps has increased commission risks where advisers are incentivized through commissions to move investor accounts to
platforms.311
2. MiFID and retail market conflict-of-interest risk
Although an obligation to avoid prejudicial conflicts of interest is implicit
in the Article 19(1) fair treatment principle, conflict-of-interest management is expressly addressed by MiFID’s generic conflicts regime, Articles
13(3) and 18,312 and by a specific regime governing inducements (section
X below). Conflicts of interest in the trading process are also governed by
the best execution and order-handling regime (chapter 6).
The generic conflicts-of-interest regime is designed to contain damaging conflicts ex ante through identification and management techniques.
Firms must take ‘all reasonable steps’ to identify conflicts of interests
(Article 18(1)) and to adopt organizational and administrative arrangements with a view to taking ‘all reasonable steps’ to prevent conflicts of
interest from adversely affecting client interests (Article 13(3)). Where the
organizational and administrative arrangements adopted are not sufficient
to ensure ‘with reasonable confidence’ that risk of damage to client interests
will be prevented, the firm must clearly disclose the general nature and/or
the sources of the conflicts of interest to the client before undertaking business on its behalf (Article 18(2)). This regime is supported by a principlesbased level 2 framework which addresses conflict identification.313 It is
also supported by an organizational requirement for a conflicts-of-interest
policy314 which must identify the circumstances which may give rise to
a damaging conflict of interest315 and specify the procedures for managing conflicts and for supporting independence. Although the level 2
311
312
313
314
315
ASIC, Managing Conflicts of Interest, p. 11.
Amplified by the Level 2 Directive, Arts. 21–23.
Art. 21 requires firms to take into account a series of non-exhaustive and potentially
conflicted situations in identifying conflicts.
Art. 22.
Firms must pay ‘special attention’ where combinations of investment research and advice,
proprietary trading, portfolio management and corporate finance activities occur.
246
investment advice and product distribution
regime suggests the procedures which may be ‘necessary and appropriate’
to support independence, the determination of particular organizational
requirements remains for the firm to determine.316
In the asset management context, and although the fair treatment obligation and the generic conflicts-of-interest regime provide background
supports, EC investor protection has not directly tackled the difficult
market structure questions raised by bundling and softing arrangements (which also arise with respect to collective asset management
and the UCITS regime).317 A disclosure-based approach, albeit confined
to the UCITS sector, was adopted in the UCITS Summary Prospectus
Recommendation.318 The MiFID inducements regime also provides a
mechanism for the control and disclosure of dealing commissions in the
form of inducements, but it does not apply to collective asset managers,
the disclosure requirements are generic and high level and the rules do not
engage directly with the risks of bundling and softing. The FSA’s concern
that the inducements regime was not sufficiently specific to address the
market failures surrounding dealing commissions, given the considerable
evidence of failures in the UK and the over-consumption of services by
managers,319 led to an Article 4 notification concerning the FSA’s disclosure rules for dealing commissions and the restrictions imposed on the
services which may be received by managers.320 CESR has consulted on
whether a common approach should be developed at level 3, but appetite
seemed to be limited, with concerns as to the typically local nature of these
arrangements and support for an industry approach.321 While regulatory
intervention may follow, it does not form part of the UCITS IV reforms
316
317
318
319
320
321
Art. 22(3). These include Chinese Walls to control information flows, the separate supervision of persons in potentially conflicted situations and ensuring remuneration is not
subject to conflict-of-interest pressures.
E. Wymeersch, Conflicts of Interest – Especially in Asset Management (Financial Law Institute Gent, Working Paper No. 2006–14, 2006), p. 4, available via www.law.ugent.be/fli/.
European Commission Recommendation 2004/384/EC of 27 April 2004 on some contents
of the simplified prospectus, OJ 2004 No. L144/42 (‘Simplified Prospectus Recommendation’), para. 2.2.2.2.
UK Article 4 Application. The retained COBS rules are designed to build on the MiFID
inducements regime.
Soft commissions have been the subject of close regulatory attention in the UK, following
the Myners Review (Institutional Investment in the UK: A Review (HM Treasury, 2001))
and are addressed by COBS 11, 15 and 18 which restrict the goods and services which
may be received by discretionary and collective asset managers (in essence they must not
impair the firm’s ability to act in the best interests of the investor) and impose disclosure
requirements.
CESR/07-316, p. 12.
the investment firm/investor contract
247
and there seems to be limited appetite to revisit MiFID’s conflicts-ofinterest regime. The ability of local regimes to address this specific question, and of Article 4 notification to contain specific solutions addressed
to MiFID-scope asset managers, as well as the likely complexity of any
response, calls for caution in the adoption of a harmonized approach.
But it certainly stands as an example of the difficulties in capturing the
range of risks faced by retail investors under a generic, principles-based
regime.
Successful management of conflicts of interest, particularly under a
principles-based model, and certainly in the EC where there are limits
on the ability of investors to take private actions, depends on effective
enforcement by supervisory authorities.322 The regime’s success rests to
a large degree, therefore, on the effectiveness of supervisory practices,
communications with the regulated community and supervisory experience in managing a flexible, outcomes-driven regime. The weakening of
more detailed organizational requirements (by Article 4) may ultimately
prejudice investor protection, particularly in those markets where market
discipline is weaker, investors are inexperienced in monitoring, and supervisory resources are more limited.323 More seriously, however, the generic
regime does not appear to be notably successful in addressing the most
acute retail market risks concerning commissions in the sales and advice
process (section X below).
VIII. Regulatory technique (5): the investment
firm/investor contract
Notwithstanding the imbalance in bargaining power between retail
investors and investment firms, regulatory intervention in the substance of
the bargain between the retail investor and the investment firm is typically
associated with prejudicial paternalism324 and is limited in the EC investor
protection regime. This stance mainly reflects, however, the sensitivities
attendant on private law harmonization. CESR’s initial highly interventionist approach to the firm/investor bargain under MiFID325 generated
very considerable market resistance, based on the doubtful competence on
which CESR’s recommendations were based and the very substantial costs
of ‘re-papering’ contracts. Close negotiations in the European Securities
322
324
Ferrarini, ‘Contract Standards’, 34–5. 323 Enriques, Conflicts of Interest, pp. 334–8.
Camerer et al., ‘Behavioural Economics’. 325 1st Mandate Advice, pp. 59–64.
248
investment advice and product distribution
Committee (ESC)326 led to a light-touch approach, designed to allay concerns as to potential interference with national private law.327 But these
sensitivities have had legacy effects in the form of a regime which assumes
that rational investors will bargain for appropriate protections and which
may carry some risks to retail investors.
Harmonization risks aside, attempts to impose notional standards of
substantive contractual ‘fairness’ through legislative fiat are, however, perilous as a significant incursion into freedom of contract. In the investment
field, this argument might appear all the stronger given the strength of
the caveat emptor principle and the generally heavy (although diminishing) reliance on disclosure and informed decision-making. On the other
hand, process-related distribution rules and product requirements might
be regarded as default contracting rules328 which recognize the very limited bargaining power of the retail investor, while the fair treatment principle admits the possibility of a fairness assessment with respect to the
firm/investor balance of power. More generally, the prevalence of standard
form contracts, information asymmetries and limited consumer competence has led to the recognition that some intervention in the substance of
the contractual bargain may be warranted. This assumption is reflected in
the Unfair Contract Terms Directive,329 which is of some importance to
retail investors,330 and seeks to impose standards of ‘fairness’ on private
bargains by providing that certain ‘unfair contract terms’331 will not be
326
327
328
329
330
331
ESC, Minutes, 29–30 March 2006 and 26–7 April 2006.
The sensitivities are clear from the Commission’s statement that the Directive does not
impose requirements on the form, content and performance of contracts, which are left to
the discretion of the Member States: Background Note, p. 21. A similar assertion is made
in recitals 41 and 62 of the MiFID Level 2 Directive.
Ferrarini, ‘Contract Standards’.
It has been described as ‘the first incursion of Community law into the heartland of national
contract law thinking’: S. Weatherill, EU Consumer Law and Policy (2nd edn, Cheltenham:
Edward Elgar, 2005), p. 115. The Commission has proposed that the Directive, along with
other key contractual measures in the consumer field, be incorporated into a horizontal
directive which would be based on maximum harmonization: Directive on Consumer
Rights (COM (2008) 614).
The FSA’s FSCP has highlighted the importance of the Directive (Annual Report 2007–
2008, p. 33), which has also been monitored by the FSA (Fairness of Terms in Consumer
Contracts: Firms’ Awareness of and Compliance with the Unfair Contract Terms Regulations
1999 (Consumer Research No. 66, 2008)).
The Annex to the Directive sets out an ‘indicative and non exhaustive’ (Art. 3(3)) list
of terms. Where certain of these terms are used by suppliers of (undefined) financial
services, exemptions are available which are designed, like the DMD’s withdrawal regime,
to reflect rapidly changing conditions in financial markets, although consumer protection
conditions apply.
the investment firm/investor contract
249
binding on the consumer where, contrary to the requirements of good
faith,332 they cause a significant imbalance, to the detriment of the consumer, in the parties’ rights and obligations under the contract (Article
3(1)), and as long as they are not individually negotiated; standard form
contracts are, however, likely to be the norm between retail investors and
investment firms. The limiting bargaining power of retail investors is also
reflected in the withdrawal right provided by the DMD, which represents
the high water mark of direct EC intervention in the firm/investor contract,
despite some earlier enthusiasm for mandatory contractual protections.333
Despite its contractual context, the Unfair Contract Terms Directive might, however, be best regarded as a creature of regulation and
public enforcement, rather than as a measure which enhances private bargaining and enforcement; the FSA has highlighted unfair contract terms as a strong indicator of firm failure to implement TCF
principles and regards fair terms as representing an important part
of the delivery of TCF outcomes throughout the product life-cycle.334
This approach also suggests a relationship between breach of the Article 19(1) fair treatment principle and firm reliance on unfair contract terms. It might also be suggested that, because investor protection is now mainly a function of conduct-shaping rules, policed, it is
likely, by supervisory enforcement, contractual rights and obligations
and private enforcement may become somewhat eclipsed. Certainly,
MiFID does not focus much attention on the investor/investment firm
contract, although contracts for MiFID services, by implication, must
comply with MiFID’s obligations335 and the fair treatment principle.
Article 19(7) simply requires the investment firm to establish a documentary record of the relevant rights, obligations and terms of the
relationship.
332
333
334
The good faith concept, which has been extensively examined, reflects the civil law tradition. Some indications as to its sweep are given in the recitals to the Directive which,
inter alia, suggest that good faith may be satisfied where the seller or supplier deals fairly
and equitably with the other party whose legitimate interests he has to take into account.
Good faith should also be assessed by reference to the strength of the parties’ bargaining
positions, whether the consumer was induced to enter into the contract, and whether the
goods and services were supplied to order.
The Commission’s 2000 Report on the Implementation of the Unfair Contract Terms
Directive (COM (2000) 248) supported a clear and standard contractual framework in
the field of cross-border provision of financial services (although the Commission also
reported that unfair terms in investment contracts represented only 2 per cent of the unfair
terms reported).
FSA, Business Plan 2008–2009, p. 25. 335 Ferrarini, ‘Contract Standards’.
250
investment advice and product distribution
IX. Segmentation risks
1. The UCITS regime
The uneasy intersection between sectoral product regulation and horizontal advice/distribution regulation in retail market regulatory design is
well illustrated by the MiFID/UCITS interaction. The UCITS Directive
does not currently address the marketing of UCITS units by the UCITS
or its manager; direct UCITS marketing also falls outside MiFID. Any
UCITS may advertise its units in the Member State in which it passports, but it must comply with the ‘provisions governing advertising’ in
that Member State, as well as any rules applicable which fall outside the
Directive’s coverage (Article 44(2)). Host State control over UCITS marketing appears to encompass marketing techniques, publicity and distribution infrastructures.336 Host State control may therefore support investor
protection, and address failures in product targeting and in choice of
distribution channel, which are not addressed by the UCITS Directive,
by allowing Member States to limit the marketing of complex UCITS
III products, in particular, to ‘qualified investors’, as defined in national
law.337 The background Treaty freedoms, and particularly the freedom to
provide services, suggest that any restrictions would have to comply with
the European Court of Justice’s jurisprudence on national rules which
restrict Treaty freedoms, which requires, inter alia, that the restriction is
in the public interest. It may be that a public interest argument could be
made. Complex products which have not been adequately targeted to a
particular market might, under the UCITS passport, be unleashed on an
inexperienced and vulnerable market. Some leeway for national authorities in the interests of investor protection appears reasonable, although
the threat of protectionism remains. Article 44 may therefore provide
a safety valve for local market concerns. In practice, however, Member
States differentiate sharply between product regulation (and adopt generally facilitative approaches, authorizing a wide range of products for public distribution) and horizontal distribution-related selling and marketing
restrictions.338 The UCITS IV Proposal, however, promises to enhance
the marketing regime and to align UCITS marketing more closely to
336
337
338
ESC, Minutes, 17 November 2006.
The Delmas Report argued robustly that the ability of the host State to restrict the
marketing of complex UCITS to sophisticated investors was implicit in Art. 44: Delmas
Report, pp. 10, 13 and 25.
Following a Commission request in March 2007, CESR collated practices across the
Member States. The report was discussed in the ESC: ESC, Minutes, 13 September 2007.
segmentation risks
251
MiFID’s model. It proposes a new marketing obligation for UCITS, based
on the principle that all marketing communications must be fair, clear and
not misleading, and be consistent with prospectus disclosures, although
it does not incorporate MiFID’s more detailed marketing requirements
(Article 77).
Difficulties also arise with distribution and commission risks. In practice, many UCITS sales take place through entities associated with the
UCITS or are proprietary sales, thus restricting competition and increasing conflict-of-interest risk. National distribution systems in the form
of local banc-assurance (financial supermarket) institutions339 dominate.
This distribution structure raises a series of risks to investor choice and
informed decision-making. Quality of advice risks arise where proprietary products are sold (section X below). ‘Closed distribution networks’
are difficult to access by cross-border or third-party UCITS products,340
particularly given high ‘retrocession’ access fees which are often passed
on to investors, typically in the form of management fees;341 distribution
charges amount to two-thirds of total expenses incurred by EC investors,
as compared to one-third in the US market,342 and can represent as much
as three-quarters of costs in some Member States.343 As a result, high distribution costs can prejudice competition and efficiency and weaken the
ability of the UCITS industry to support long-term savings. Inclusion of
a product within a network may also suggest a quality label to investors,
although inclusion may be fee-driven rather than based on performance.
The more limited range of products carried by closed networks344 may
also prejudice the quality of advice. UCITS providers may be compelled
to wrap a UCITS in other product wrappers to facilitate its distribution,
which may distort the application of key MiFID regulatory disciplines,
particularly where an insurance wrapper is used. UCITS distribution is
339
340
341
342
343
344
Sect. X below.
Asset Management Expert Group, Financial Services Action Plan: Progress and Prospects
(2004), p. 21.
L’Observatoire de l’Epargne Europ´eenne (OEE) and Zentrum f¨ur Europ¨aische
Wirtschaftsforschung (ZEW), Current Trends in the European Asset Management Industry
(2006), pp. 9–10.
European Commission, Financial Integration Monitor (SEC (2006) 1057), p. 22.
European Commission, Impact Assessment of the Legislative Proposal Amending the UCITS
Directive (SEC (2008) 2236), p. 12.
It was reported in 2005 that 46 per cent of CIS distributors did not offer one third-party
scheme, while, of those networks which were ‘semi-open’, 33 per cent offered fewer than
five third-party schemes: European Commission, Green Paper on the Enhancement of the
EU Framework for Investment Funds (COM (2005) 314), p. 13.
252
investment advice and product distribution
undergoing change,345 however, as the industry slowly moves towards a
more competitive ‘open’ or ‘guided’ architecture model under which intermediaries, including independent advisers, fund supermarkets and banks
which offer third-party products, offer a range of UCITS products. But
commission risk then arises which may prejudice the quality of advice
as well as prejudicially influence the range of schemes carried; in the UK
market, the FSA has pointed to the risk that product providers compete for
distribution on commission rates and adjust commission in ways which
can lead to unsuitable sales.346
Whether or not MiFID’s distribution and advice regime will, where it
applies, capture distribution risks in the indirect sale of UCITS is not clear.
The Commission appears unsure and is to monitor the resilience of the
regime for UCITS distribution.347 Related disclosure reform concerning
the cost structure of CISs and distribution costs is also being canvassed
(chapter 5), but effective costs disclosure is very difficult to design and has
had only limited success in addressing conflict-of-interest risk.
2. Structured and substitute products
MiFID’s generic, principles-based regime, on the face of it, is sufficiently
flexible to address mis-selling risks in the distribution of MiFID-scope
structured retail products, and particularly the risks associated with
capital-protected products where a careful assessment of the guarantee
must be made.348 But its success depends on MiFID’s effectiveness ‘in
action’ and is uncertain. CESR’s review of the Lehman collapse suggests
some concern as to the recent quality of advice concerning structured products, as does the FSA’s 2009 decision to review marketing and the quality of
advice in this area.349 The UK experience with structured ‘precipice bonds’
had earlier shown the potential for mis-selling risks. Designed to deliver
a high income, they did not provide capital protection. Although the FSA
issued a series of risk alerts, retail investors sustained very considerable
345
346
347
348
349
As was reported in two major reports prepared for the European Commission: OEE and
ZEW, Current Trends, p. 7; and Oxera, Current Trends in Asset Management: Prepared for
the European Commission (2006), pp. iii and vii.
FSA, Financial Risk Outlook 2007, p. 96.
Commission, UCITS IV Impact Assessment, p. 13.
D. Waters (FSA), Speech on ‘Industry Response to Developments in Regulation of
Structured Products’, 12 February 2009, available via www.fsa.gov.uk/Pages/Library/
Communications/Speeches/index.shtml.
CESR, Lehman Default, p. 3; and J. Hughes, ‘Products Backed by Lehman Spark FSA
Probe’, Financial Times, 8 May 2009, p. 3.
segmentation risks
253
losses as the market dropped and a series of enforcement actions followed
based on suitability failures.350 Structured products are also often sold
without advice through execution-only sales;351 whether the conditions
which apply to determining whether the product is ‘non-complex’, and so
eligible for execution-only sales, are sufficiently calibrated and robust can
be unclear.
But MiFID applies only to MiFID-scope investments. While these
include a wide array of investments, including structured products, UCITS
units and non-UCITS units, MiFID does not, reflecting international
practice,352 cover unit-linked investment products, the distribution of
which is often subject to the Insurance Mediation Directive (IMD). The
IMD applies to insurance agents and brokers but not to employees of
insurance companies.353 In addition to imposing registration requirements on insurance agents and brokers, it imposes limited disclosure and
quality of advice/conflict-of-interest rules. Prior to contract conclusion,
brokers must provide investors with certain disclosures concerning the
firm354 and its status (Article 12(1)). The latter disclosures, which are not
mirrored in MiFID, address the independence or otherwise of the intermediary. The intermediary must disclose whether: advice is given on a
‘fair analysis’ basis; whether the broker is under a contractual obligation
to conduct insurance mediation business exclusively with one or more
insurance undertakings (and their identities); or whether the intermediary is not under a contractual obligation to conduct insurance mediation
business exclusively with one or more insurance undertakings and does
not give advice on a ‘fair analysis’ basis (in which case the identities of the
undertakings with which the intermediary may and does conduct business
must be supplied). This disclosure obligation is supplemented by controls
350
351
352
353
354
The FSA fined, for example, the Bradford and Bingley Building Society £650,000 for
failing to make suitable recommendations, not maintaining adequate records of sales
and not having in place adequate systems and controls to address mis-selling failures:
FSA/PN/112/2004.
The Dutch AFM, for example, recently reported that 95 per cent of structured products
‘find their way to investors directly, without the mediation of an adviser’: AFM, Exploratory
Analysis of Structured Products (2007), p. 4.
Joint Forum Report, pp. 3 and 50.
Which was of some concern in the Delmas Report (p. 18).
Art. 12 requires, inter alia, that the intermediary disclose whether the intermediary has
a holding, direct or indirect, representing more than 10 per cent of the voting rights or
capital of a given insurance undertaking, whether a given insurance undertaking (or parent
undertaking) has a holding, direct or indirect, representing more than 10 per cent of the
voting rights or capital in the insurance intermediary and provide disclosure concerning
complaints and redress (Art. 12(1)(a)–(e)).
254
investment advice and product distribution
on the nature of ‘fair analysis’ advice, which must be given on the basis of a
‘sufficiently large’ number of insurance contracts available on the market
to enable the intermediary to make a recommendation, in accordance with
professional criteria, regarding which contract would be ‘adequate’ to meet
the customer’s needs (Article 12(2)). In a quasi-know-your-client requirement, prior to the conclusion of any specific contract the intermediary
must at least specify, on the basis of information provided by the customer, the demands and needs of that customer as well as the underlying
reasons for any advice given to the customer on a given insurance product (Article 12(3)). MiFID’s considerably more extensive fair treatment,
marketing, suitability, conflict-of-interest/commission risk and contract
requirements do not apply to insurance brokers or to insurance products.
The distribution of, and advice with respect to, structured deposit-based
products, which are outside MiFID’s scope, is not subject to any specific
harmonized requirements.
This segmented regime generates particular difficulties concerning
commission risk. As discussed in section X below, MiFID imposes disclosure and inducement rules which, while problematic, are designed
to alleviate the risks of commission bias in the sale of MiFID-scope
instruments. The regulatory arbitrage risks in the distribution of unitlinked investments355 and deposit-based investments are therefore considerable, given that distributors have incentives to promote, and advise
on, products which are not subject to MiFID disclosure and inducement
requirements.356
The treatment of marketing and advertising risks is also uneven. Marketing risks are considerable with respect to structured products, as suggested by the precipice bond and split-capital investment trust failures in
the UK357 and the mis-selling of guaranteed fonds a` promesse in France.358
It remains to be seen whether MiFID’s generic Article 19(2) requirement that communications be ‘fair, clear and not misleading’ is sufficiently robust. Offerings of structured securities are also subject to the
355
356
357
358
The BME Report linked the growth of unit-linked products at the expense of CISs to
differential regulatory treatment under MiFID in particular: BME Report, p. 67.
As has been frequently noted by the EC institutions and CESR; for example, Klinz II
Resolution, paras. 12–19.
The FSA estimated in 2003 that 250,000 consumers had invested £5 billion in precipice
bonds: FSA/PN/026/2003. It issued alerts as to the risks of these investments repeatedly,
particularly in 2001 and 2002, but action was also subsequently taken against investment
firms for mis-selling. See also n. 350 above.
Delmas Report, p. 9.
segmentation risks
255
Prospectus Directive359 which, under Article 15, requires that related
advertisements highlight the publication of a prospectus and be accurate, consistent with the prospectus and not misleading. But the marketing of non-MiFID-scope structured deposits and unit-linked insurance is governed by the more general requirements of the horizontal
consumer-protection marketing regime, including the DMD and the UCP
Directive.
Member States may, however, choose to apply MiFID disciplines to
providers of non-MiFID products and services, particularly as the IMD is
a minimum-standards measure and given the absence of relevant banking
sector rules. A number of Member States have extended MiFID’s distribution rules.360 These include the FSA which, reflecting FSMA, adopts a
‘level playing field’ approach to firms dealing with retail clients and has
extended MiFID’s conduct-of-business requirements to non-MiFID firms
and businesses.361 As a result, the scope for regulatory arbitrage in the
UK is limited.362 MiFID’s principles-based model certainly lends itself to
a cross-sector application. Indeed, the extent to which MiFID is being
used as a template for product distribution across the Member States suggests a new form of quasi-harmonization, as well as the risk that MiFID’s
weaknesses will be injected across the advice and distribution sector more
generally.
It now appears that the substitute products policy debate363 has led
the Commission to suggest a massive recasting of the harmonized advice
and distribution regime. Its April 2009 Packaged Products Communication has suggested that the ‘fragmented regulatory patchwork’ be replaced
by a coherent, cross-sector horizontal ‘selling’ regime addressing conflict of interests, inducements and conduct-of-business regulation; the
IMD and MiFID may, if the Commission is successful, be repealed and
359
360
361
362
Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003
on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64 (‘Prospectus
Directive’).
Ireland, Italy, Portugal, the UK, the Czech Republic, France and Germany all, to varying
degrees, adopt a horizontal approach to the major categories of retail investment products: European Commission, Feedback Statement on Contributions to the Call for Evidence
on ‘Substitutive’ Retail Investment Products (2007), pp. 33–4; and the European Commission impact assessment for the Packaged Products Communication (SEC (2009) 556),
pp. 45–6.
The FSA’s approach has been to impose MiFID standards, for the most part, on regulated
firms in the retail advice and product market (including with respect to unit-linked
insurance). See ch. 1.
FSA Substitute Products Response, p. 2. 363 See further ch. 3.
256
investment advice and product distribution
replaced by a new measure which will apply to sales of ‘packaged products’ by distributors/advisers and by product providers.364 Level 1 principles and level 2 detailed rules for the sale of specific products are
envisaged.
While the harmonized regime certainly leads to inconsistencies in sales
practices, particularly with respect to sales of unit-linked insurance products, which are popular EC retail investments, this ambitious project is
risk-laden, as discussed in chapter 3. The risks are exacerbated in the selling context as there is still only limited experience with MiFID although
it is being used widely across the EC as a template for product sales. The
Commission has suggested that MiFID could act as the benchmark for the
new cross-sector selling regime and hailed it as a ‘sophisticated regime’ for
the management of conflict-of-interest risk.365 But MiFID, as discussed
in the following sections, is not well equipped to deal with access to
advice risks and the risks of commission-based sales. This new adventure
on which the Commission is embarking may prove to be an unwelcome
distraction and the costs may outweigh the benefits. Allocating policy
resources to ‘advice in action’, and in support of local solutions to commission risk and access to advice difficulties, might be a more efficient
response.
X. Advice or sales? Addressing the ‘right risks’
1. Delivering high-quality investment advice
MiFID’s articulation of investor protection in the advice and distribution context is troublesome. Effective regulatory design ‘in action’ in
this context requires sensitivity to the channels through which advice
is delivered and their risks. The distinguishing feature of MiFID ‘investment advice’ is that it is personal, specific and tailored to an assessment
of the investor’s circumstances (section II.3 above). But MiFID ‘investment advice’ does not fully capture the nature of the EC’s advice and
distribution industry, which incorporates fee-based independent advisers
364
365
European Commission, Communication from the Commission to the European Parliament
and the Council: Packaged Retail Investment Products (COM (2009) 204), pp. 6 and 9. The
Commission has suggested that the regime cover conduct of business, conflict-of-interest
management and inducements, and include: a fair treatment principle; suitability rules
where advice is given; disclosure concerning the limits of execution-only services; conflictof-interest management; clear disclosure on remuneration; and an obligation that those
assessing product suitability fully understand the product sold (p. 11).
Packaged Products Communication, pp. 7 and 10.
advice or sales? addressing the ‘right risks’
257
and commission-based advisers, single and multi-tied agents in product
providers’ distribution networks and bank-based advisory/sales services
linked to the distribution of proprietary products. In practice, the structure
of the Community advice industry suggests that ‘advice’ is better characterized in terms of product ‘sales’ by banks and commission-based advisers,
rather than in terms of independent, personalized advice services. But the
MiFID regime grapples only indirectly with the related nuanced and difficult questions concerning adviser remuneration, incentives and industry
structure which in practice drive the quality of investment advice and
particularly ‘sales’. Nor, despite the policy concern to promote informed
investor decision-making, does MiFID focus closely on the sustainability
of the advice industry or investor access to advice services. Although these
weaknesses might be better regarded not as specific failures of EC policy
but as a reflection of the limitations of law in the retail markets, a more
muscular approach to the delivery of investor protection in the advice
context is emerging in some quarters.
2. Incentive and commission risks: advice or sales?
Independent, objective, fee-based and accessible investment advice is
often regarded as representing the zenith of product distribution/advice
policy,366 not least given the higher levels of trust and the consequent
potential for stronger market engagement associated with fee-based
advice.367 Suitability requirements similarly assume, or strive towards, personalization and objectivity in the advice relationship. But the widespread
availability of independent, objective investment advice is an elusive goal
which is very difficult to achieve through regulation given the extent
to which ‘advice’ in practice takes the form of the distribution or sale
by banks of proprietary products or is based on commission-based
remuneration.
Commission-based remuneration, and remuneration-based incentive
structures related to the distribution of proprietary products, generates
serious risks for investors. Remuneration structures have very considerable
366
367
2007 RDR, Annex 3, p. 2.
While allowance must be made for its articulating an industry position, APCIMS challenged the FSA’s critical review of the retail market in its 2007 RDR, arguing that low
levels of trust in the sale of investment products were not reflected in the asset management/brokerage/advice industry, which had seen a 55 per cent increase in discretionary
mandates between 2002 and 2006: APCIMS, Response to DP 07/1, 13 December 2007.
258
investment advice and product distribution
potential to misalign incentives,368 as has already been made graphically
clear by the Enron-era scandals369 and by the financial crisis.370 The welldocumented risks371 include biased advice,372 failures to provide debtreduction advice, poor product selection373 and inappropriate advice to
switch products,374 all of which can be exacerbated in difficult market
conditions when investors are already vulnerable to market risks,375 and
ultimately mis-selling. This is clear from recent German evidence376 as
well from the FSA’s persistent difficulties in embedding strong suitability
disciplines, misalignment between UK investors’ risk appetites and the
investment products they hold377 and repeated UK mis-selling failures,
as outlined in this section below. The risks are all the greater given the
368
369
370
371
372
373
374
375
376
377
M. Krausz, and J. Paroush, ‘Financial Advising in the Presence of Conflicts of Interest’
(2002) 54 Journal of Economics and Business 55.
E.g. J. Coffee, ‘Understanding Enron: It’s the Gatekeepers, Stupid’ (2002) 57 Business
Lawyer 1403.
FSA, The Turner Review: A Regulatory Response to the Global Banking Crisis (2009) (‘Turner
Review’), pp. 79–81.
The risks of commission-based services in the brokerage context were, for example, examined in detail by the SEC’s 1995 Tully Committee (D. Tully and A. Levitt, Report of the
Committee on Compensation Practices (1995)) which recommended as best practice those
commission practices which aligned investor and broker interests and which led to wider
use of fee-based brokerage accounts.
Although many retail investors probably benefited from advice from continental banks
to switch to deposits over 2008, one commentator has suggested that ‘it could . . . have
proved bad for customers had markets gone in the other direction. Banks did not redirect
savings in expectation of a market crash but to serve their own purposes [in rebuilding
balance sheets]’: P. Skypala, ‘FSA Has Chance to Clarify “Sales” and “Advice”’, Financial
Times, Fund Management Supplement, 24 November 2008, p. 6.
ASIC has reported that advice that was clearly or probably non-compliant with suitability
requirements was six times more common where advisers had an actual conflict of interest
concerning remuneration: ASIC, Shadow Shopping, p. 8.
The FSA has reported that ‘concerns around bias and churn feature highly in most
countries’: 2007 RDR, Annex 3, p. 2.
In the UK, adviser failure to advise investors in ‘with-profits’ unit-linked products to
switch out of these products before the market collapsed has been linked to commission
incentives: A. Ross and S. Goff, ‘Advisers Criticized over Savings Plans’, Financial Times, 23
January 2009, p. 4. The FSA also reported that commission rate increases were used during
difficult trading conditions over the credit crunch to stimulate sales of life assurance bond
products: 2008 RDR Feedback Statement, p. 28.
A recent German study has suggested that bank advisers have incentives to promote
equity-concentrated asset allocation as equity products have higher margins: Jansen et al.,
The Influence of Financial Advice.
As noted in ch. 2, FSA research points to a persistent pattern of investors with no willingness
to take on risk holding equity-based products.
advice or sales? addressing the ‘right risks’
259
difficulties vulnerable, trusting investors, hamstrung by poor decisionmaking, face in identifying conflict-of-interest risk and assessing relevant
disclosures.378 The delivery of objective investment advice is all the more
an intractable problem as investors display a well-documented reluctance
to pay a fee for advice.379
Some very heavy lifting is demanded of regulation in delivering
incentive-alignment and good-quality objective advice in a commissionbased and proprietary-product sales-based environment. Although commission risk is a common problem internationally,380 the difficulties
are particularly pronounced in the Community where the fee-based,
independent-adviser model, and investor reliance on advice outside of
commission-based or proprietary product sales, is rare. Investment advice
and product distribution typically occurs through commission-based
tied agents of product providers (e.g. Germany381 ), multi-tied agents
who advise on a range of products (e.g. Netherlands) and integrated
banc-assurance (financial supermarket) banking models (e.g. Germany,382
France,383 Spain and Italy384 ).385 Overall, banks are key suppliers of ‘advice’
378
379
380
381
382
383
384
385
Langevoort has suggested that the question as to ‘why do investors so readily pay for and
accept so much investment advice, especially from sources subject to palpable conflicts
of interest’ is one of the more puzzling phenomena in economics, finance and securities
regulation: Langevoort, ‘Selling Risk’, 633.
Sect. XI below.
New Zealand’s 2008 reforms to investment advice include enhanced disclosure requirements concerning commissions and fees (www.newsecuritieslaw.govt.nz), while the
Australia–New Zealand Shadow Financial Regulatory Committee has highlighted the
incentive risks in commission-based advice (Australia–New Zealand Shadow Financial Regulatory Committee, Responding to Failures in Retail Investment Markets, Statement No. 3, 25 September 2007, p. 3). The Canadian Deaves study highlighted the
risks posed by the trust placed by investors in advisers and commission-rich products (R. Deaves, C. Dine and W. Horton, How Are Investment Decisions Made?,
Research Study prepared for the Task Force to Modernize Securities Legislation in
Canada (2006) (‘Deaves Report’)), commission risks were the subject of the US
Tully Committee, while the Joint Forum highlighted commission risks and called for
appropriate incentive structures to be adopted for sales forces: Joint Forum Report,
p. 6.
BaFIN, Annual Report 2005, p. 128.
One study has suggested that two-thirds of investors obtain financial advice through a bank
while only 20 per cent rely on independent financial advisers: Bluethgen et al., Financial
Advice.
Bank (and insurance) networks dominate: Delmas Report, p. 10.
Bank branches generate approximately 70 per cent of total commission income on investment products and services in Italy: CONSOB, Annual Report 2006, p. 76.
2007 RDR, Annex 3, p. 5; and BME Report, pp. 100–47.
260
investment advice and product distribution
and investments, particularly CISs386 and bonds.387 The recent explosion in the sale of structured products reflects this trend, with banks
accounting for 86 per cent of retail market sales and independent advisers accounting for 12 per cent.388 The bank model is also growing in
some Member States, with Dutch banks, for example, increasingly acting as ‘financial centres’ and servicing a wide range of financial needs.389
Long-standing cultural practices, such as the familiarity of consumers
with local branch networks and agents, have driven these advice and distribution practices; so too have different savings patterns, with greater
wealth associated with more complex investment needs and more sophisticated advice structures,390 and pension-provision patterns.391 But the
integrated-bank delivery model carries considerable incentive and misselling risks relating to internal commissions and sales targets given the
incentives to promote high-earning proprietary products.392 It also carries
risks with respect to the limited distribution of third-party products.393
386
387
388
389
390
391
392
393
BME Report, p. 113 (reporting that retail banks account for almost 80 per cent of scheme
distribution). The FSA has similarly reported that bank distribution networks account
for 86 per cent of CIS sales in Spain and 34 per cent in Germany, while advised sales in
those Member States represent 11 per cent and 26 per cent, respectively: FSA, Financial
Risk Outlook 2006, p. 52. In France, for example, 82 per cent of UCITS products are sold
through bank branches, while only 5 per cent are sold through independent advisers:
Delmas Report, Annex IV, p. 3. Sales of non-harmonized UCITS across Europe are also
dominated by banks (42 per cent), followed by insurance companies (22 per cent) and
advisers (17 per cent): PricewaterhouseCoopers, The Retailization of Investment Funds in
the European Union (2008), p. 11.
BME Report, p. 108 (of the investors surveyed, 50 per cent purchased debt securities
through banks; only 21 per cent used brokers). Similarly, ‘in most Member States, retail
clients are still heavily reliant on their local banks for investment decisions’ (Oxera, Current
Trends in Asset Management, p. iv).
Soci´et´e G´en´erale, The European Retail Structured Investment Product Market: Panorama and
Trends (2006), p. 6; in the Dutch market, which has seen strong growth, sales are typically
in the form of non-advised proprietary sales by banks: AFM, Exploratory Analysis, p. 11.
2007 RDR, Annex 3, p. 6.
The FSA has pointed to the range of factors, including tax, shifting employment patterns,
benefits systems, changing consumer behaviour and technological developments concerning product distribution, which influence the structure of the investment advice industry
(2007 RDR, p. 14), as has the BME Report (pp. 212–14).
FSC Report, p. 21.
E.g. advising on structured products in preference to bond funds: P. Skypala, ‘ETFs the
Only Bright Spot as Outflows Roll on’, Financial Times, Fund Management Supplement,
24 November 2008, p. 15. This commentator has also suggested that banks tend to ‘sell
fashionable products rather than encouraging long-term saving in core investments’:
‘Tackling the Issue of Sky-High Wages’, Financial Times, Fund Management Supplement,
30 March 2009, p. 6.
BME Report, p. 114.
advice or sales? addressing the ‘right risks’
261
Recent litigation in Germany (pre-MiFID) saw the German Federal Court
rule that, while it was within a bank’s sole discretion to offer a limited
range of ‘in-house’ products (the scheme in question was produced by
the bank’s group), and while a bank was not liable for poor advice where
it did not advise on competitor products, it was under a duty to disclose
whether it earned a sales commission in order to alert the investor as to the
conflict of interest.394 The distinction between ‘advised sales’ subject to the
full rigours of the MiFID investment advice regime and execution-only
non-advised ‘sales’ may also blur. The 2005 Delmas Report highlighted the
importance of suitability disciplines being applied to ‘advised sales’, that
the distinction between non-advised, execution-only sales and ‘advised
sales’ should be made clear and that sales advisers should be provided
with advice supports in the form of, for example, standard know-yourclient/suitability questionnaires.395 The Dutch AFM has also noted the
importance of providers of proprietary products complying with advice
requirements.396
Commission risks also arise with ‘open-architecture’, commissionbased product distributors, whether in the form of ‘independent’ advisers or networks of agents.397 Although ‘independent’ financial advisers
are slowly becoming more popular across Europe,398 notionally ‘independent’ investment advisers are generally uncommon and dominate in
only one Member State, the UK.399 Sixty-four per cent of all reported
investment product sales in the UK took place on an advised basis in
2007–8,400 and commission-based ‘independent’ advice by small, often
MiFID-exempt ‘Article 3 firms’401 dominates (although not all advisers
are commission-based). Underlining the difficulties the EC faces in supporting the quality of advice through harmonized measures, adviser dominance reflects in part the local popularity of complex packaged products
394
395
397
398
399
400
401
Bundesgerichtshof, 19 December 2006, available in (2007) Zeitschrift f¨ur Bank- und
Kapitalmarketrecht 160.
Delmas Report, pp. 32 and 46. 396 AFM, Priorities 2007–2009, p. 24.
Delmas Report, pp. 11–12 and 38. The BME Report also pointed to heavy consumer
reliance on ‘advisers’ whose income depends heavily on commission and the related risk
of incentive misalignment (p. 183).
Ibid., p. 116.
Over 5,000 notionally independent ‘whole of the market’ advisers, largely paid by commission, account for more than 75 per cent of all sales of CISs: UK Article 4 Application,
pp. 12–13.
FSA, Retail Investments Product Sales Data Trends Report September 2008 (2008), p. 2.
Although these firms fall outside MiFID, the FSA has applied the MiFID advice regime.
Sect. II.4 above.
262
investment advice and product distribution
as UK household investments. But commission-based remuneration and
adviser distribution has been associated with a range of failures, including poor-quality advice, a series of mis-selling scandals402 (notably with
respect to pension schemes, precipice bonds and split-capital investment
trusts403 ), excessive product switching, viability risks to the distribution
sector and increased claims on the FSA’s investor compensation scheme.404
Incentive risks are exacerbated by poor levels of financial literacy, increasing product complexity and the limited ability or willingness of retail
investors to exercise choice, which leads to competition among product providers for distribution channels, rather than for investors, and an
increased likelihood of commission risk.405 All this has led to a lengthy,
and thus far relatively fruitless, struggle by the FSA to address deep-seated
conflicts-of-interest risk. While rooted in the particular features of the
UK market, the risks of the UK market and the repeated reform attempts
have, nonetheless, relevance for EC distribution and advice policy. This
is not only because they highlight the need for flexibility. The wider EC
movement towards the support of independent advice (section XI below)
is an important feature of the UK policy debate, while, notwithstanding
the importance of ‘independent’ advisers, the classic conflict of interest
associated with retail market ‘advice’ and ‘sales’ in continental Europe
and related to proprietary ‘sales’ by banking groups is also found in the
UK.406
In this distribution-based and deeply conflicted European environment,
heroic regulatory design efforts ‘in action’ are required to support vulnerable and trusting investors in what is often a commission-based sale or a
sale of a proprietary product, and in which suitability and other supplyside protections, notably the fair treatment principle, may be disabled by
entrenched and flawed incentives. The demands on regulation are all the
greater as MiFID must capture, given the Article 4 gold-plating restriction, a range of different distribution and advice channels and their risks.
402
403
404
405
406
The persistence of commission risk and the history of mis-selling by the personal investment firm industry were both highlighted in the UK’s Article 4 application to retain its
discrete packaged products regime: Article 4 Application, pp. 12–14.
E.g. A. Lang, ‘Investment Firms – Retail Sector’ in W. Blair and G. Walker (eds.), Financial
Services Law (Oxford: Oxford University Press, 2006), p. 449, pp. 451–3.
2007 RDR, pp. 4, 17 and 50; and Financial Risk Outlook 2007, pp. 10 and 95–6.
Ibid., p. 96.
In 2007–8, 46 per cent of investment products (predominantly CISs (including UCITS)
and unit-linked investment products) and 47 per cent of tax-wrapped Individual Savings
Accounts (ISAs) investments were sold via banks and building societies and products were
often proprietary: FSA, Retail Investments Product Sales Data, pp. 2 and 12.
advice or sales? addressing the ‘right risks’
263
But the treatment of commission risk must be at the heart of regulatory
design for the pan-EC market given investor dependence on distribution
and advice channels and the limitations of allied product regulation and
disclosure strategies.
3. MiFID and commission risk
a) The demand side: disclosure
As outlined in chapter 5, MiFID relies in part on disclosure to manage
commission risks. The effectiveness of disclosure in this sphere is doubtful,
although in the long term it may support better investor monitoring.
b) The supply side: advice or sales; conflict-of-interest requirements
or detailed suitability rules?
Supply-side rules must carry out the heaviest lifting in protecting retail
investors against incentive risk. MiFID’s articulation of investor protection in the advice relationship in part in terms of suitability requirements may well respond to the risks of the asset management/full-scale
advice sector. But the emphasis on personalized suitability requirements,
which are difficult to embed and enforce, sits uneasily in a environment
dominated by sales risks and in which investors are purchasers of products and do not usually seek fee-based, extensive advice. The suitability
regime does provide an ex ante mechanism for focusing firm attention on
the investor’s needs in the sales context; it also provides an ex post private
or public enforcement mechanism. But supervision and enforcement is
challenging in this context, and severe incentive misalignment may disable
suitability protections. The Article 19(1) fair treatment obligation might
also be called in aid, particularly with respect to ex post enforcement. But
the effectiveness of this provision depends in large part on the consistency
with which it is applied and how it is embedded.
Of more importance is the extent to which internal systems to manage
incentive misalignment are embedded ex ante within a firm’s culture, particularly as MiFID identifies situations in which the firm has an interest in
the outcome of a service provided to a client or a transaction carried out
on behalf of a client, which is distinct from the client’s interest, as carrying
conflict of interest risk (MiFID Level 2 Directive, Article 21). Firms should,
accordingly, have systems to manage remuneration-based conflicts, based
on the general obligation to manage conflicts (MiFID Level 2 Directive,
Article 22); this obligation might also be inferred from the fair treatment
264
investment advice and product distribution
principle. The FSA has targeted objective remuneration (linked to indicators such as the incidence of complaints, portfolio reviews and investor
satisfaction) in its TCF reviews407 and best practice advice.408 Objective
remuneration has also been raised by other Member State regulators,409
internationally,410 and by leading trade associations.411 But the success of
Article 22 (MiFID Level 2 Directive) and Article 19(1) (MiFID) in dealing
with commission risk is heavily dependent on national supervision and/or
quasi-regulatory guidance and is vulnerable to the wider risks of the fair
treatment and conflict-of-interest regimes.
Considerably more specific protections are provided by the level 2
inducements regime, which, as has been acknowledged by the FSA, represents an important addition to the investor protection arsenal.412 Under
the MiFID Level 2 Directive, Article 26, inducements are prohibited unless
particular conditions are met. CESR has also adopted important, if controversial, level 3 Guidance on Inducements.413 While the inducements
regime includes a disclosure element (chapter 5), it also, and primarily,
imposes fiduciary-style duties on the investment firm. Under Article 26,
the Article 19(1) fair treatment obligation is not met where the firm is provided with any fee, commission or non-monetary benefit which does not
meet the Article 26 conditions. The first condition (Article 26(a)) is met
where the fee, commission, or non-monetary benefit is paid or provided to
or by the client or a person on behalf of the client. Article 26(c) allows the
payment of ‘proper fees’ which enable or are necessary for the provision
of investment services414 and which, ‘by their nature’, cannot give rise to
407
408
409
410
411
412
413
414
In its ‘cluster report’ on remuneration and TCF, the FSA warned of the need to further
align the commercial need to sell products with the aspiration to treat customers fairly and
that further progress was needed in building factors other than short-term profit variables
into remuneration packages.
E.g. FSA, Quality of Advice Process.
Delmas Report, p. 37; and BaFIN, Annual Report 2006, p. 136.
ASIC has suggested that remuneration structures be linked to, for example, the incidence
of complaints, continuing education and the quality of advice (ASIC, Conflicts of Interest),
while the Joint Forum Report suggested that firms consider remuneration systems that
reward compliance with the highest suitability and disclosure standards: Joint Forum
Report, p. 52.
ESF, CMA, ISDA, SIFMA (the Joint Associations Committee), Retail Structured Products:
Principles for Managing the Distributor – Individual Investor Relationship (2008), Principle
3.
The new regime is more extensive than the pre-MiFID FSA regime, particularly with
respect to the requirement that the payment be designed to enhance the quality of the
service and disclosure: FSA, Consultation Paper No. 06/19, pp. 32–3.
CESR, Inducements under MiFID (CESR/07-228b, 2007) (‘Inducements Guidance’).
Including custody costs, settlement fees and legal fees.
advice or sales? addressing the ‘right risks’
265
conflicts with the firm’s duties to act in accordance with the best interests
of the client. The central condition (Article 26(b)), which applies to all
other payments if they are to escape the Article 26 prohibition, requires:
disclosure of the inducement/payment; that the payment is designed to
enhance the quality of the service; and that it must not impair compliance
with the firm’s duty to act in the best interests of the client.415 Commission
payments linked to product sales and advice clearly come within Article 26
in principle. But, unsurprisingly, given the structure of the advice industry,
the regime does permit commission payments, as long as the advice is not
biased and the Article 26 conditions are met.416 CESR has also advised that
payment for product distribution, where no advice or recommendation is
provided, is legitimate as the firm is providing quality enhancement in the
form of distribution services which, in the absence of the payment, might
not be provided, and as long as the disclosure and best interest conditions
are met.417 The inducement regime is considerably more detailed than
the fair treatment principle; but it is also considerably more operational,
with CESR’s Guidance containing a number of illustrative examples, the
overall tenor of which suggests some concern to preserve existing distribution agreements and to acknowledge the distribution service provided by investment firms, but also a focus on conflict-of-interest risk
where the risk of incentive misalignment becomes more acute.418 CESR
was also concerned to ensure that intra-group inducements are covered
and that payments made in the context of ‘open-architecture’ distribution are treated equally with payments between legal entities within the
same group.419 The regime is also likely to capture ‘hidden commissions’,
notably the non-cash benefits which flow from the product provider to
the investment firm (such as office facilities and administrative support),
although MiFID does not address how these benefits might be quantified
415
416
417
418
419
CESR’s Guidance identified the range of factors to be considered as including: the type
of service provided and the specific duties owed to the client; the expected benefit to the
client, including the nature and extent of the benefit and any expected benefit to the firm;
whether incentives have arisen for the firm to act other than in the best interests of the
client and whether they are likely to change firm behaviour; the relationship between
the firm and the entity providing the benefit; and the nature of the benefit (recommendation 4).
MiFID Level 2 Directive, recital 39; and Inducements Guidance, recommendation 5.
Inducements Guidance, p. 10 and recommendation 5.
The examples include CESR’s view that it would be difficult to meet the Art. 26(b)
requirement where a one-off or ‘override’ payment is made once sales of a particular
product reach an agreed level as the risks of conflict of interest increase as product sales
approach the payment threshold.
Inducements Guidance, p. 4.
266
investment advice and product distribution
and how investor understanding of the hidden costs of advice might be
enhanced.420
The inducement regime has some potential to contain the risks of
commission-based advice/sales, as long as it is rigorously enforced, and
it has enjoyed support from retail market stakeholders.421 But the MiFID
rulebook is only a partial response to the commission-risk debate. Much
remains to be done in terms of its effectiveness ‘in action’ and in terms of
examining and assessing its impact in practice and enhancing supervision
and enforcement. As discussed in the following final two sections, the
delivery of mass market quality advice also demands strenuous efforts ‘in
action’ beyond traditional regulation if commission risk is to be mitigated
and the advice lever is to be able to carry out the heavy lifting required
to engage and protect investors. Although ‘in action’ strategies remain
largely the preserve of the Member States, EC resources would be well
spent in supporting and encouraging more innovative local strategies for
addressing commission risk.
XI. Fee-based investment advice: segmenting regulated advice
1. Delivering independent investment advice: the UK Retail
Distribution Review and other international experience
A more radical response might be to consider whether fee-based independent advice could be supported by harmonized regulation. Engineering
the retail advice and distribution markets to deliver particular outcomes
is a complex undertaking, however, and demands nuanced regulatory
choices and considerable supervisory expertise.
Internationally, the US regulatory regime has struggled with the
labelling and differential regulatory treatment of ‘investment advisers’,
who, broadly, provide fee-based advice, are not involved in the management of trading accounts, are regarded as fiduciaries and are subject
420
421
The FSA successfully included its pre-MiFID requirement that commission-equivalents
be disclosed in cash terms in its Article 4 Application in order that investors understand
the full costs of the service and to promote market transparency and market discipline:
Policy Statement No. 07/14, p. 14.
The FSA’s FSCP supported CESR’s approach, arguing that ‘it is critically important that
all necessary measures are taken to maintain and boost consumer confidence’: FSCP,
Response to CESR’s Public Consultation CESR/06-687 Inducements under MiFID (2007),
p. 1. Similarly, FIN-USE highlighted the importance of the regime in its criticism of CESR’s
failure to highlight it in the CESR MiFID Consumer Guide: FIN-USE, Letter to CESR on
A Consumer’s Guide to MiFID, 24 May 2008.
fee-based investment advice
267
to stringent fiduciary duties, and ‘broker-dealers’, who provide account
management and broking services but only provide advice incidentally,
are, broadly, associated with commission-based remuneration and are not
regarded as fiduciaries. As both perform very similar functions, the SEC
has grappled for some time with the distinction, particularly as investment advisers must be registered under, and are regulated by, the 1940
Investment Advisers Act, and as broker-dealers are not subject to this
Act but must be members of a self-regulatory organization under the
1934 Securities Exchange Act (in practice, FINRA422 ) and are subject to
SEC and FINRA conduct rules (although the investment adviser regime
is perceived as being stronger).423 Following repeated attempts to adopt
rules to clarify the status of broker-dealers who offer fee-based brokerage accounts424 and the striking-down of a remedial 2005 SEC rule, the
SEC commissioned the extensive 2008 Rand Report on the investment
advice and brokerage industry.425 It found that the advice industry supported a range of business models and that, although investors appeared
generally satisfied with the advice services available, they did not understand the regulatory distinction. It suggested that the key driver for distinct treatment was not (unlike the developing UK regime) the form of
compensation but whether the adviser or the investor made the investment decision. As part of its now-overtaken post-credit-crunch reform
agenda for the US regulatory and supervisory system, the 2008 Treasury
‘blueprint’ also criticized the bifurcated system as having failed to adjust to
market realities and caused investor confusion and called for a harmonized
regime.426
In the EC, the FSA’s repeated struggles with product distribution and
mass market advice are instructive, if, until recently, disheartening. While
reflecting the particular risks of the UK market, they serve as a more general
422
423
424
425
426
The Financial Industry Regulatory Authority was formed in 2007 from a merger between
the NASD (the previous self-regulatory organization for broker-dealers) and the member
regulatory, enforcement and arbitration units of the New York Stock Exchange.
For a discussion of the investment adviser/broker-dealer controversy, see the 2008 ‘Treasury
Blueprint’ for a remodelling of US financial market regulation: Department of the Treasury,
Blueprint, pp. 118–26.
In the wake of the recommendation by the Tully Commission that broker-dealer remuneration be related to assets managed rather than trading activity, many broker-dealers
who previously had operated on a commission basis began to offer fee-based accounts.
Rand Institute for Civil Justice, Report on Investor and Industry Perspectives on Investment
Advisers and Broker-Dealers: Sponsored by the SEC (2008).
Department of the Treasury, Blueprint, pp. 13 and 125–6. Similar concern was expressed
in the 2009 proposals: Department of the Treasury, Financial Regulatory Reform (2009),
p. 71.
268
investment advice and product distribution
warning as to the challenges raised by intervention to address commission
risk and industry structure and as to the scale of the regulatory ‘technology’
and resources required. The UK investment advice and distribution regime
has experienced a series of reforms designed to address commission risk,
but, after more than twenty years of intervention, the FSA’s conclusion
was that regulation had tended to focus on ‘the symptoms arising from
problems rather than the root cause’ and that insufficient progress had
been made towards a market which delivered services which reflected
consumer needs.427
Support of fee-based independent advice has been a recurring and
problematic theme. The advice and distribution industry was ‘polarized’ in
1987, by law, into independent advisers (who acted as investors’ agents and,
in compliance with a ‘best interests’ requirement, advised on the market
range of products) and tied agents (who acted as product providers’ agents
and could advise only on that provider’s products);428 disclosure requirements applied to highlight the adviser’s regulatory status, as did conflictof-interest requirements.429 Following concerns that this approach was
anti-competitive and not delivering benefits to investors,430 the ‘depolarization’ reforms,431 which came into force in June 2005, allowed firms to
choose whether to be tied to one product provider, multi-tied, untied and
commission-based ‘whole of the market’ firms or independent advisers
advising on ‘whole of the market’ products and offering a ‘fee option’. The
depolarized regime initially relied heavily on disclosure to manage incentive risks, in the form of a ‘Menu’, which required firms to disclose the
maximum commission they received on products as well as the market
average for a range of products, and in the form of an Initial Disclosure Document (IDD) on the type of service provided432 these requirements were reformed and lightened post-MiFID (chapter 5). Conflict-ofinterest and commission risks are also dealt with through labelling-style
427
428
429
430
431
432
2007 RDR, p. 5. Its 2007 Risk Outlook similarly noted that, while the sale of retail investment products had been subject to regulation for more than two decades, shortcomings
continued to emerge in the way in which products were sold and with respect to the quality
of advice: Financial Risk Outlook 2007, p. 10.
Black, Rules and Regulators, pp. 138–84, examines the political, market and institutional
tensions which accompanied the initial polarization reforms.
In particular, product providers were to make efforts to ensure that appointed representatives were not incentivized by remuneration structures to give unsuitable advice.
Office of Fair Trading, The Rules on Polarization and Investment Advice (1999).
See generally I. MacNeill, An Introduction to the Law on Financial Investment (Oxford
and Portland, OR: Hart Publishing, 2004), pp. 168–9; and FSA, Reforming Polarization –
Making the Market Work for Consumers (Consultation Paper No. 121, 2002), pp. 10–14.
FSA, Reforming Polarisation: A Menu for Being Open with Consumers (Consultation Paper
No. 04/3, 2004).
fee-based investment advice
269
controls on the term ‘independent’, which can only be employed where the
adviser (with respect to personal recommendations concerning packaged
products) advises on a ‘whole of the market’ range of products and offers
investors the option of paying a fee.433 But this attempt to promote feebased advice has proved troublesome given the strong incentives generated
by commission payment, with the FSA reporting that a number of firms
do not offer investors a fee option and, in some cases, that investors are
dissuaded from paying a fee.434 The UK experience has also been that
investors find it difficult to decode labels and do not equate commission
payments, even with specific disclosure, with potential prejudice to the
independence of advice.435
Despite these reform efforts and a matrix of suitability, conflict-ofinterest and disclosure requirements, persistent failures in the advice
and distribution system, industry consensus that reform is required,436
and an over-arching, empowerment-driven concern to ensure that individuals are better equipped to take on responsibility for welfare provision and long-term financial planning, led to the FSA’s groundbreaking 2007 RDR437 which completed its initial consultation phase in late
2008.438 It has the potential to alter radically UK advice and distribution. It forms part of a wider reform strategy for advice and distribution
which includes reform of conflicts-of-interest disclosure,439 prudential
regulation440 and the treatment of platforms and wraps.441 The RDR
strand is designed to address a series of market flaws which, reflecting
433
434
435
437
438
439
440
441
A firm may not hold itself out as independent in relation to advice (or personal recommendations) on packaged products unless it intends to look across the ‘whole of the market’
(or the whole of a sector of the market) in making a recommendation and offers a client
a fee (rather than commission) option with respect to the packaged product transaction
(COBS 6.2.15 and 6.2.16).
FSA, Investment Quality of Advice Processes II (2008), p. 3.
FSA, Consultation Paper No. 121. 436 2007 RDR, p. 13.
Although it warned that it is not the role of government or regulators to dictate business
models, the Treasury welcomed the 2007 review given that a ‘more efficient distribution
system that aligns the interests of firms and clients, and improves access to financial
services, will help to promote consumer confidence and a willingness to engage with
financial services’: HM Treasury, Financial Capability, p. 17.
The 2008 RDR Feedback Statement followed almost two and a half years of discussion
and marked the beginning of the formal consultation process on specific proposals. It is
expected to be implemented, following consultation on related rule changes, by December
2012.
See further ch. 5.
FSA, Discussion Paper No. 07/4; FSA, Feedback Statement No. 08/2; and FSA, Review of the
Prudential Rules for Personal Investment Firms (Consultation Paper No. 08/20, 2008).
FSA, Discussion Paper No. 07/2; and FSA, Platforms and More Principles-Based Regulation
(Feedback Statement No. 08/1, 2008).
270
investment advice and product distribution
the interplay between disclosure, distribution and product regulation,
include: the complexity of retail investment products and their charging
structures; limited financial capability and retail investors being unable
to act as a strong force on the industry; heavy reliance on commissionbased advisers and interest misalignment; access to advice difficulties; and
limited adviser competence.442 Its ambition is considerable. Investor protection is not characterized in terms of traditional conduct regulation
and disclosure ‘on the books’. It is characterized in terms of a radical reengineering of the structure of the retail distribution and advice market443
to deliver better outcomes for consumers through a clearly segmented
distribution and advice system; this new system is designed to distinguish between sales and advice, provide clarity on the different services
provided, raise professional standards and reduce conflicts of interests in
remuneration.444 Support of independent, fee-based advice is at the heart
of the new system.
The initial 2007 proposals were based on segmenting the industry into,
first, an independent, fee-based (or ‘customer-agreed-remuneration’)
financial planning and advice sector, which would separate the product costs from advice costs, deliver the highest standards of competence
and be targeted to more affluent investors with more complex needs445
and, secondly, a low-cost advice/sales segment, designed to facilitate mass
market access to advice and to address closely ‘sales’ risks. At the heart of
this policy therefore is the assumption, which cuts against MiFID’s design,
that regulatory models for investment advice which merge independent
investment advice and product distribution/advised sales, using common
conduct and disclosure requirements, are flawed, and that a distinction
must be made between highly regulated and fee-based investment advice
and other forms of transaction-based advice and distribution to mitigate
investor confusion and risks to the objectivity of advice.
The independent advice strand, which, from the outset, enjoyed considerable support,446 was based on ‘eroding the perception that advice is
442
443
444
446
2007 RDR, pp. 3–4. The FSA found that only 10 per cent of advisers holding the basic
entry-level qualification received higher qualifications (p. 16).
Although the review is designed to act as a ‘catalyst to facilitate, where we can, industry
solutions that will improve market efficiency and lead to better outcomes for consumers’:
FSA, Business Plan 2008–2009, p. 27.
2008 RDR Feedback Statement, p. 3. 445 2007 RDR, p. 22.
The FSA’s FSCP highlighted the attempt to promote fee-based advice as ‘one of the most
important developments in financial regulation since the FSA was created’: 2006–2007
Annual Report, p. 2.
fee-based investment advice
271
a free commodity’447 and on supporting a move from transaction-based,
product-driven services to fee-based advisory services. The ‘independent’
label was, accordingly, to be reserved for advisers who met the highest
standards of competence and professionalism but who also were, in a
robust attempt to address conflicts of interest, only remunerated by fees
or by ‘customer-agreed-remuneration’; the latter could take the form of
commission, but only as long as this was agreed by the investor. Sustainability concerns were also addressed, with the increased costs of this service
related to a ‘regulatory dividend’ in the form of lighter prudential supervision related to the firm’s risk management profile.448 Higher standards
of professionalism were also highlighted, reflecting a concern that competence improvements were needed to restore investor trust in advice.449
Additional categories of advice included ‘general financial advice’, which
could be provided by commission-based advisers who had less in-depth
knowledge or qualifications, and ‘focused advice’, which could be provided
by ‘top tier’ and ‘general’ advisers.450
This segmentation was expected to carry out some very heavy lifting in
that it was to remove the potential for remuneration-linked conflicts of
interests, advice costs were to be separated from product costs, the adviser’s
freedom from potential product bias would be more clearly signalled,
product providers would be required to compete on quality rather than
on commission (and might have incentives to produce less complex and
more effective products) and the likely lower incidence of mis-selling was
to support industry sustainability.451 The new regime was also associated
with better investor engagement with the investment process given greater
clarity on the advice process and closer investor involvement in establishing
remuneration.
While initial reaction was positive, the FSA withdrew its proposal to
segment the market into ‘independent advice’ and ‘other advice’ channels.
It adopted instead a radical model under which all ‘advisers’ would be
independent and subject to enhanced regulatory requirements, including
a prohibition on commission (unless it was agreed with the customer)
and higher professional standards; all other services and transactions
would be classed as sales.452 In its final 2008 RDR discussion, although
the advice/sales segmentation became more nuanced (section XII below),
the core distinction between ‘independent advice’ and other sales, including advised sales, was maintained; this approach was also followed in the
447
450
2007 RDR, p. 55.
Ibid., pp. 25–7.
448
451
Ibid., pp. 42–3. 449 Ibid., p. 6.
Ibid., pp. 24 and 32–3. 452 2008 Interim RDR.
272
investment advice and product distribution
June 2009 proposals (section XII below). Under the new model, ‘independent advice’ will be subject to rigorous remuneration rules designed to
remove product provider influence, high professional standards and additional quality of advice requirements. The pivotal remuneration regime,
based on ‘adviser charging’, is considerably more practical, eschewing the
troublesome consumer-agreed model which had limited practicality given
limited investor competence (although it chimed well with the FSA’s fondness for empowerment strategies). It will require independent advisers to
set advice charges independently and disclose them to investors; product
provider influence over remuneration will be removed, although providers
may provide facilities whereby preset adviser charges are, under a ‘matching’ system, deducted from products’ costs, in a lump sum or periodically,
and passed to the adviser.453 A step-change in professional standards will
also follow. The RDR is to lead to the establishment of a statutory Professional Standards Board which will adopt professional standards and
review compliance across all independent and non-independent advice
channels.454 Additional suitability requirements, akin to the ‘whole of
the market’ rule,455 will also be imposed, which will require independent
advice firms to be equipped to give a comprehensive and fair analysis of
their relevant markets;456 firms will also be required to provide unbiased
unrestricted advice.457
So how does this robust approach ‘in action’ to reforming advice and
addressing commission risk fit with MiFID? The reforms certainly highlight the limitations of the traditional disclosure, suitability and conflictof-interest rules ‘on the books’ which remain at the heart of MiFID. They
also highlight the need for flexibility given the difficulties distribution and
453
454
455
456
457
Reflecting in part the reality that many investors prefer instalment payments and that
firms may prefer periodic charges for advice which are designed to align firm and investor
incentives more closely: 2008 RDR Feedback Statement, p. 33. Any arrangement under
which product providers advance advice fees to advisers and recover these through product
charges will, however, be prohibited from December 2012.
Ibid., pp. 47–52.
Although this rule only applies to packaged product providers and the new regime will
apply to all independent advisers.
The rule is based on the principle that independent advisers be able to review the whole
market but acknowledges that the relevant market may be differently defined, for example,
where an firm restricts itself to an ethical investments strategy but defines the market in
an independent manner and discloses this clearly: ibid., pp. 42–3.
E.g. ‘independent’ advice firms with contractual links with product or service providers
could breach this requirement where those links limit their ability to select the best solution
for the investor (such as choice of a platform which only offers the platform provider’s
products).
fee-based investment advice
273
advice can pose locally given a Member State’s particular market features.
But the FSA’s ability to deliver its radical independent advice model will
be constrained by EC rules,458 unless these ‘top tier’ advisers can be carved
out from MiFID by an exemption; given that these advisers are likely to
engage in asset management, this is unlikely as the Article 3 exemption
will not be available. The Article 4 gold-plating exemption provides a
safety valve, however, which the FSA is likely to open.459 The Commission
certainly has little to gain from refusing an Article 4 application where the
result may be to expose weaknesses in MiFID or to expose it to charges
of obstructing retail market efficiencies at a time of heightened political
focus on the retail investor.
2. An EC model?
Management of commission risk through support of an independent,
fee-based advice industry is emerging as a preferred policy option, not
just in the UK but across the Member States.460 FIN-USE has repeatedly raised concerns as to commission bias461 and access to independent
advice in markets where tied advisers dominate462 and suggested that regulation ‘of some form’ might be needed to facilitate the emergence of
independent advice.463 The Commission, which had shown an earlier,
if poorly executed, enthusiasm for an independent advice model during MiFID negotiations,464 warned in its 2007 Green Paper on Retail
Financial Services that the sales and distribution infrastructure ‘is not
458
459
460
461
462
463
464
Ibid., p. 33.
It is ‘fully prepared to make cases where necessary to achieve the outcomes of [the]
review’: 2007 RDR, p. 74. Thus far, the Commission seems supportive: Consultation Paper
No. 09/18, p. 6.
BME Report, p. 181. The Delmas Report, for example, supported the encouragement of
fee-based advice, noting that it ‘will take time’ (Delmas Report, p. 12), and examined the
ways in which it could be encouraged (p. 40).
Its first report in 2004 noted that investors were dependent on ‘sound independent advice’
and raised the risks of distribution structures and investor lack of awareness as to whether
advisers were tied or independent: FIN-USE, User Perspective, pp. 26 and 28.
FIN-USE, Response to the Green Paper on Financial Services Policy 2005–2010 (2005); and
FIN-USE, Opinion on the European Commission Green Paper on the Enhancement of the
EU Framework for Investment Funds (2005).
FIN-USE, Response to the Green Paper on Financial Services Policy, p. 10.
The Commission’s 2001 ‘Initial Orientations’ for ISD reform suggested that ‘advice’ could
be defined as ‘independent investment advice’ paid for by the client and distinguished from
the provision of advice through tied agents (Commission, Overview of Proposed Adjustments, p. 11). It did not, however, reflect market realities, with the Commission somewhat
helplessly acknowledging that the treatment of advice in the sale of proprietary products
274
investment advice and product distribution
always optimal’;465 the subsequent consultations also raised the difficulties posed by the sales/advice tension.466 The European Parliament has
highlighted the importance of access to ‘unbiased investment advice’,467
while a key report by the Council’s influential Financial Services Committee has warned that the capacity of existing EC distribution channels
to deliver the required advisory and sales services is underdeveloped and
poses a risk to effective retirement provision.468 Commission risks have
also been a recurring feature of the recent consultations on substitute
investment products.469
As long as investors suffer from competence difficulties in decoding
commission risks, and depend on advice services but have limited ability to drive optimum services, and while supply-side regulation remains
problematic in the face of entrenched commission risk, the use of more
muscular regulatory/supervisory devices ‘in action’ to influence the structure of the advice industry seems reasonable. But the risks of an EC strategy are considerable. As outlined in section X, delivery channels for advice
across the EC industry vary, reflecting different industry, cultural and
savings influences. Were a fee-based model to be canvassed, any reforms
would have to grapple with the very considerable investor resistance to
fee-based investment advice470 and the strength of the perception that
advice is free where the adviser receives a commission. Intense education
of investors as to the benefits of fee-based advice, and the implications
465
466
467
468
469
470
was ‘unclear’. Following support during the consultation process for the independence of
advice to be supported through background conflict-of-interest and disclosure techniques
(European Commission, Revised Orientations on ISD Reform (2002), Annex 4, p. 16), the
latter model was followed in MiFID.
European Commission, Green Paper on Retail Financial Services, p. 17.
European Commission, Report of Hearing on Green Paper on Retail Financial Services
(2007), p. 4.
European Parliament, Resolution on Financial Services Policy (2005–2010) (P6 TA(2007)
0338, 2007) (‘Van den Burg II Resolution’), para. 36.
FSC Report, p. 21.
E.g. Investment Management Association, Response to Commission Call for Evidence
(2007), p. 4.
Recognition of investor reluctance to pay a fee is a recurring theme of recent major policy
reviews and studies including: the Delmas Report (p. 39); the FSA’s RDR (2007 RDR, p. 49)
(the FSA noted the ‘generally held view’ that consumers in the mass market will not pay
a fee for advice); FSA, Accessing Investment Products (Consumer Research No. 73, 2008),
p. 2 (finding a ‘real resistance’ to paying for advice in cash rather than through ‘more
invisible’ charges and commissions)); and the pan-EC 2008 Optem Report (finding that
inexperienced consumers did not envisage paying a fee for advice (p. 100)).
fee-based investment advice
275
of different advice labels, would be required;471 and EC policy has up to
now struggled with education and disclosure techniques ‘in action’. The
risks in terms of supporting wider access to advice are considerable; some
evidence suggests that commission-based advisers are more receptive to
investors who might, initially at least, be unprofitable.472 The direct policy
levers are limited and the regulatory choices are, as the US and UK experience underlines, complex. They are also, particularly where prohibitions
on commissions are concerned, politically combustible given the structure
of the EC advice industry.
On the other hand, EC regulatory policy has until now reflected the
traditional focus on disclosure, suitability and conflict-of-interest requirements ‘on the books’ in managing advice risks. The FSA approach builds on
this model (as it must), but it is also based on a muscular, outcome-based
strategy ‘in action’ designed to focus on how the outcome of independent
advice can be delivered and on a more careful atomization of the nature
of investment advice. Although the FSA review is rooted in the UK marketplace, the centrality of investment advice to investor-protection policy,
particularly given weaknesses in allied product and disclosure regulation,
might call for a little more drilling beneath the surface and some exploration of which regulatory levers might support the development of a
viable, but high-quality, fee-based, independent advice industry.
So, acknowledging that the large-scale engineering proposed by the
FSA is impracticable and inappropriate to the fragmented EC market,
the question arises how best to proceed in segmenting the advice market,
at Community level, to promote a fee-based independent advice sector?
Viability is a key risk. Some traces of a concern to support sustainable,
independent, fee-based advice can be identified in MiFID. MiFID applies
a lighter regulatory regime to investment firms which only provide investment advice or transmit orders and do not hold client assets, but which
do not benefit from the Article 3 exemption.473 Although these firms are
subject to the conduct-of-business and conflict-of-interest regime, they
benefit from lighter prudential controls and initial capital requirements.
471
472
473
J. Lee and J. Cho, ‘Consumers’ Use of Information Intermediaries and the Impact on Their
Information Search Behaviour in the Financial Markets’ (2005) 39 Journal of Consumer
Affairs 95.
Research for the FSA has suggested that commission-based firms are more willing to take
on client relationships which are unprofitable: Deloitte and Touche, Costing Intermediary
Services: A Report for the FSA (2008).
See sect. II above on Art. 3.
276
investment advice and product distribution
They must either provide initial capital of €50,000,474 have professional
indemnity insurance meeting MiFID’s coverage requirement or rely on a
combination of insurance and capital which results in an equivalent level
of coverage. The final option allows firms to reduce the MiFID capital
charge by holding insurance, and reflects the similar regime which applies
to insurance brokers under the Insurance Mediation Directive. This
regime is based on the assumption that insurance is an adequate means
of protecting investors where mis-selling represents the most serious risk,
where client assets are not held and where counterparty risk is limited.475
But it also supports the development of fee-based independent investment
advice in that new entrants could face high barriers to entry were high
capital requirements imposed. Insurance-related regulation carries, however, moral hazard risks, particularly as insurance cover tends not to be
based on individual firm risk assessment, as well as the risk that insurance
becomes more difficult for firms to obtain where there is insufficient
capacity in the insurance market.476 It is not yet clear whether the MiFID
regime and its incorporation of an insurance requirement is distorting the
insurance market.477 Article 5(5) also reduces the regulatory burden by
providing that Member States may allow competent authorities to delegate
administrative, preparatory or ancillary tasks relating to the authorization
of these firms, a relaxation which also applies to ongoing supervision of
authorization and compliance with MiFID’s operational requirements.478
Fee- and advice-based services might develop organically in response
to industry trends, technological developments and investor demand, in
474
475
476
477
478
The capital regime applies via Directive 2006/49/EC, OJ 2006 No. L177/201 (CRD).
The Commission argued that firms of this type do not represent a source of counterparty
or systemic risk but that the main risk to which investors were exposed was of a failure of
‘due diligence’ with respect to the advice given: European Commission, MiFID Proposal
(COM (2002) 625), p. 81.
The capital charge option was introduced following Member State and Parliamentary
concern that indemnity insurance might become more difficult to obtain and that excessive burdens might be imposed on firms providing investment advice and insurance
mediation: Final Report of the European Commission on the Continued Appropriateness
of the Requirements for Professional Indemnity Insurance Imposed on Intermediaries under
Community Law (COM (2007) 178).
The 2007 Commission Report on the indemnity regime found that the policy justification
remained sound and that there was insufficient evidence to indicate that reforms were
necessary. But it focused on the insurance mediation regime and acknowledged that no
evidence was available on the MiFID regime. An FSA study into the insurance market for
non-MiFID ‘Article 3 firms’ has also found that the market is working efficiently: Feedback
Statement No. 08/2.
Arts. 16(2) and 17(2).
fee-based investment advice
277
which case the appropriate policy response may be simply not to obstruct
innovation and to ensure the robust application of core MiFID disciplines.
Significant growth in the market for high-quality, independent advice, at
the expense of financial-supermarket banks, has been predicted.479 Spain,
for example, has seen demand rising for independent advice as investment products have become more sophisticated and financing needs more
complex, as has Germany.480 A shift from product-oriented marketing by
banks to client-oriented services has also been predicted.481 The recent
development of platforms and wraps, while in some respects increasing
conflict-of-interest risk, has also been associated with reducing reliance on
commissions and with a movement away from product transactions and
towards ongoing, fee-based, advisory relationships.482 The growing popularity of exchange-traded funds in some markets is also reducing pressure
on commission risks as these products are not commission-based.483
A more radical approach might be to encourage segmentation by reference to the UK model and with a voluntary, but pan-EC, ‘label’ or ‘kite
mark’, associated with fee-based advice and high standards of competence, particularly as MiFID deals only tangentially with competence.484
Adviser competence is becoming an EC policy concern, linked to the
concern that advisers do not always understand the products they sell,
but reform efforts are not consistent485 and competence standards and
professional oversight are typically a function of national regimes. But,
even if an appropriate model, linked to harmonized national competence
standards, could be designed, the difficulties investors face in decoding
different ‘labels’ are considerable. The political risks are also significant
given the dominance of the bank/financial-supermarket model and resistance from interest groups.486 Segmentation/labelling reforms might also
479
482
483
484
485
486
Note 36 above. 480 2007 RDR, Annex 3, pp. 3 and 6. 481 BME Report, p. 168.
FSA, Discussion Paper No. 07/2 and 2008 RDR Feedback Statement, p. 4, noting a growing
focus on asset allocation, risk and performance rather than on product selection. Initial
commission payments have reduced in Australia following the development of wraps and
platforms: 2007 RDR, Annex 3, pp. 2 and 8.
2008 RDR Feedback Statement, p. 28.
Investment firms must ensure that ‘relevant persons’ (Art. 2(3)) are aware of the procedures
which must be followed for the proper discharge of their responsibilities and employ
personnel with the skills, knowledge, and expertise necessary for the discharge of their
assigned responsibilities (MiFID Level 2 Directive, Art. 5(1)(b) and (d)).
BME Report, p. 181. The Report pointed to Sweden’s 2004 law on financial advice which
requires financial advisers to have formally demonstrated competence on financial instruments and the regulatory framework.
R. Rajan and L. Zingales, ‘The Great Reversals: The Politics of Financial Development in
the Twentieth Century’ (2003) 69 Journal of Financial Economics 5.
278
investment advice and product distribution
represent a poor use of scarce resources; extensive fee-based advice is only
likely, initially at least, to be of significant interest to more affluent and
sophisticated investors. The immediate concern of advice policy must be
the mass market, which is ill-equipped to navigate a complex universe
of different advice providers, unlikely to be in need of complex financial
advice and not in a position, or disinclined, to pay fees. It may be that this
group is best dealt with by ensuring the regulatory regime focuses sharply
on the particular confusion and commission risks of ‘advised sales/sales’
‘in action’ and, in particular, on the rigorous enforcement of conflict-ofinterest/inducement and suitability rules.
Domestic measures designed to address fee-based advice should also
be accommodated within the Article 4 process, although the fate of the
FSA’s RDR remains to be seen, and efforts should be made to support local
best practice and pan-EC supervisory learning, whether through CESR or
otherwise. Although the difficulties are considerable, efforts to address the
fee-based advice conundrum, however troublesome, seem a better use of
resources than the new packaged products agenda.
XII. Access to mass market advice and the sales problem
1. Access to advice
Effective regulation ‘in action’ of the advice process requires more than
management of the risks of the advice relationship. It also demands a
focus on access to advice487 as investor need for advice increases. Fullscale, highly personalized advice is costly and likely to be prohibitive
for much of the mass market.488 A tiered advice system which allows
investors to move through different forms of regulated advice, based on
graduated regulatory (and particularly suitability) regimes which allow
cost differentiation and which support the development of simpler advice
487
488
‘The regulation of a market cannot compensate for unfairness which derives from a lack
of expertise. Where such lack of expertise is combined with a lack of resources to buy in
expertise, unfairness truly exists’: Bradley, ‘Disorderly Trading’, 392. Similarly, the BME
Report highlighted the asymmetry which arises where consumers with higher incomes
and better education have access to superior advice and those most in need of advice are
unable to afford it (p. 183).
BME Report, p. 183. The FSA’s FSCP has argued that the cost of independent advice was a
‘fundamental limitation’ for consumers and that consumers were, as a result, attracted to
banks who provide a more limited ‘and probably not independent’ advice service: Response
to the Commission’s Green Paper on Retail Financial Services in the Single Market (2007),
p. 3.
access to mass market advice and the sales problem
279
channels, may better reflect investor needs.489 But the design challenges are
considerable, not least among them MiFID’s requirement for a suitability
assessment whenever a personalized recommendation is made, industry
risks where the applicability of suitability requirements is unclear and the
limited ability of retail investors to choose and monitor different advice
services.490
2. A mass market advice regime and MiFID: generic advice
MiFID allows for some degree of segmentation in that regulated MiFID
‘investment advice’ is limited to specific and personalized recommendations (section II.3 above) and does not include what can often be valuable
general asset allocation, financial planning and debt reduction advice.
This exclusion suggests a pragmatic approach to the trade-off between
protection and costs; advisers are not disincentivized from providing this
form of advice earlier in the sale or advice relationship. Hybrid advice
forms, such as guided execution-only sales which, at various stages in the
sales process, provide generic advice on asset allocation,491 may also be
supported by this model, as long as a personalized recommendation is
not made. It also reflects a pragmatic approach to the different channels
through which investors receive basic financial advice: ‘the exclusion of
generic advice . . . avoids the danger of regulating financial planning entities that, in many cases, operate as charities providing valuable financial
advice free of charge’.492
3. Access to advice and the UK experience
a) Basic advice
Investment advice in the UK has a number of regulatory dimensions.
At the bottom of the pyramid, a free, public Money Guidance advice
489
490
491
492
UK retail investors have shown a preference for simple and straightforward advice services:
FSA, Consumer Perceptions of Basic Advice (Consumer Research No. 70, 2008), p. 6.
The FSA has found that, while retail investors support simplified advice services, when
asked to design an ideal advice model they constructed a model very similar to the MiFIDbased, commission-driven, independent adviser model: FSA, Consumer Research No. 73.
The UK’s RDR suggested at an early stage that an ‘assisted-purchase’ execution-only model
could be used, outside the investment advice regime, to guide investors to make the right
decision (2007 RDR, p. 66) although considerable risks arise concerning the boundary
between non-regulated guided sales and regulated personalized advice.
Background Note, p. 31.
280
investment advice and product distribution
model, personalized but not tied to the sales process, is being trialled by
the FSA.493 But, between generic advice and MiFID-regulated investment
advice (whether by non-MiFID ‘Article 3 firms’ which follow the MiFID
regime or MiFID firms), the UK regime also includes Basic Advice.494
Basic Advice is designed to support wider access to investment products
and advice by those with no practical knowledge of investing495 and to
address advice costs and manage commission risks by linking less costly
regulatory (particularly suitability) requirements to the distribution of the
‘stakeholder’ products;496 the construction of these products is designed to
obviate the need for a close assessment of individual needs. Limited advice
is delivered by advisers operating from pre-scripted questions,497 warnings
and statements;498 a detailed assessment of the investor’s circumstances is
not made.499 Basic Advice is designed to lead to a ‘suitable’ recommendation from the limited range of stakeholder products offered and reflecting
the information provided by the investor during the sales process. The
related FSA Guidance closely reflects the risks to which inexperienced
investors with limited resources are exposed. Advisers are recommended,
for example, to provide an unambiguous warning as to the desirability of
making debt repayments, of access to liquid cash, or of acquiring insurance, where appropriate, and not to recommend equity-based investments
where the client does not wish to place capital at risk.
Its close focus on the needs of more vulnerable investors is imaginative
and laudable. But Basic Advice has had only limited success, partly given
its unattractiveness to providers given the stakeholder product charges
cap. Basic Advice investors also tend to invest only small amounts, making
supply of the products uneconomical. The target market of low to middle
income savers, while generally happy with Basic Advice,500 has also proved
493
494
495
496
497
498
499
500
See further ch. 7.
FSA, A Basic Advice Regime for the Sale of Stakeholder Products (Consultation Paper No.
04/11, 2004); and FSA, A Basic Advice Regime for the Sale of Stakeholder Products (Policy
Statement No. 04/22, 2004).
FSA Basic Advice Guidance, COBS 9, Annex 2 G.
See further ch. 3. The Basic Advice regime does not, however, apply to the stakeholder
smoothed investment product (COBS 9.6.10). The pre-scripted advice model did not
test well and investors appeared confused as to the nature of the investment: FSA, Policy
Statement No. 04/22, p. 22.
Although the FSA has developed a Basic Advice script, most firms use proprietary models:
2007 RDR, p. 58.
Policy Statement No. 04/22, pp. 3, 5 and 7.
The regime is set out in COBS 9.6. Extensive guidance is set out in COBS 9, Annex 2 G.
Consumer Research No. 70, p. 6.
access to mass market advice and the sales problem
281
smaller than initially expected.501 Concerns have arisen as to liability risks
to firms, that firm mis-selling risks may be replaced by investor mis-buying
risks502 and that an inferior service is provided to vulnerable investors.503
Basic Advice came under review during the RDR which led the FSA to
conclude that the Basic Advice market had not developed as expected
and to consult on withdrawing the regime, although it has since decided
to retain it as a form of ‘restricted advice’.504 While the FSA remains
committed to supporting a spectrum of advice services, the experience
with Basic Advice points to the commercial difficulties which can arise
in designing a lower-cost model and to the challenge posed by blending
product and advice regulation.
b) The Retail Distribution Review: primary advice and ‘sales’
Access to advice was a central theme of the RDR, related to the FSA’s
concern that retail investors should have access to low-cost advice and
that the advice sector should be sustainable.505 As outlined in section XI
above, the RDR is based on the premise that, for those who can afford
full-scale advice, this sector should be conflicts-free and expert. But significant difficulties then arise as to how to support mass market investors
who cannot afford full-scale independent advice.506 Working from the disheartening assumption that its high-quality, independent advice regime
would inevitably exclude mass market investors,507 and in order not to
exacerbate the advice gap, the FSA initially proposed a low-cost ‘Primary
501
502
503
504
505
506
507
One report estimated the target market at only 1.5 million customers: Volterra Consulting,
The Market for Basic Advice: A Report for the FSA (2008).
J. Gray, ‘The Sandler Review of Medium and Long-Term Retail Savings in the UK: Dilemmas for Financial Regulation’ (2002) 10 Journal of Financial Regulation and Compliance
385; and O. MacDonald, ‘The Sandler Review’ (2003) 11 Journal of Financial Regulation
and Compliance 102.
FSA, Policy Statement No. 04/22, p. 5.
2008 RDR Feedback Statement, pp. 65–6 and Consultation Paper No. 09/18, pp. 20–1.
The 2007 RDR argued that rising income and wealth meant an increase in those needing
financial help (p. 5), while the 2007 Outlook noted the FSA’s concern that investors were
buying products without advice (p. 9).
One commentator suggested that, although the FSA has accepted that ‘the mass market cannot afford face-to-face holistic advice’, differentiating too sharply between sales
and advice would drive advice ‘even further upmarket, increasing the gap between the
professionally served top end and the mass market, which has been abysmally served
by transaction-oriented independent financial advisers and high street banks’: S. Fowler,
‘A Simple Call for Good Retail Advice’, Financial Times, Fund Management Supplement,
9 July 2007, p. 6.
The FSA was concerned that an increase in the costs of independent advice could lead to
the exclusion of ‘middle income’ investors (£25,000–£50,000): 2007 RDR, pp. 7–8.
282
investment advice and product distribution
Advice’ model which would have seen a radical move away from personalized advice and towards suitability being assessed ‘at the level of consumer
segments’ which, while it might ‘lead to suboptimal outcomes for some,
overall . . . would put consumers in a better position than having no access
at all’.508 Like the Basic Advice regime, it would have been restricted to a
limited range of products (although wider in scope than the stakeholder
suite)509 to counteract advice risks.510
The flaws of the Primary Advice model underline the challenges of
intervention in support of easier access to advice. Drawing a line between
different forms of investment advice on a spectrum from ‘independent’,
to ‘personalized’, to ‘generic’,511 risks all manner of unintended effects,
as has been the Australian experience.512 The FSA’s original assumption
that commission risk was somehow more acceptable in certain ‘advice’
relationships is troubling. A lighter advice regime could have entrenched
lower-quality ‘advice’ in the mass market.513 The Primary Advice model
remained transaction-related and, as such, was unlikely to lead to recommendations to repay debt. Any success would have depended on industry
take-up and on the costs outweighing the more limited benefits; but Basic
Advice had already highlighted the commercial difficulties. Difficult questions also arose as to the range of products involved, the risk of distortion
to market forces and the competence of the regulatory system to design
some form of endorsement mechanism for the related products which
would not carry the risk that investors assumed some form of government
guarantee.
A simpler but more radical model was proposed in the FSA’s 2008
Interim Report. While it retained the independent advice model, the FSA,
reflecting stakeholder support for a simplified regime, concern as to any
508
509
510
511
512
513
Ibid., p. 60.
A ‘simplicity’ qualification was suggested which would have segmented products with
respect to risk, charges and other characteristics (access to capital with/without loss,
taxation, premium levels and contract length, term and ease of access to information):
ibid., p. 63.
Ibid., p. 28.
The FSA’s original model was ambitiously based on full advice, focused advice, primary
advice, generic advice, non-advised purchases and Basic Advice: ibid., p. 27.
Australia’s Financial Services Reform has struggled with the distinction between general
and personal advice and, in particular, with when firms become subject to the risk warning
requirements which attach to general advice: Treasury, Refinements Proposal, pp. 24–5.
APCIMS argued that the Primary Advice regime could amount to a second class service,
providing a convenient training ground for less-experienced advisers. APCIMS, Response
to RDR, pp. 11 and 12. Consumer reaction was also negative: FSCP, Response to a Review
of Retail Distribution, p. 3.
access to mass market advice and the sales problem
283
dilution of the ‘advice’ brand, support for a distinction between advice
and sales and hostility to the Primary Advice model,514 proposed that
all other regulated transactions, other than ‘independent advice’, were
to be classified as non-advised ‘sales’. This radical simplification of the
regulatory landscape and the distribution/advice industry, which would
have, for example, excluded tied advice from the ‘advice’ universe, was bold
and engaged directly with commission risk and with investor confusion as
to the nature of ‘advice’; it also assumed that ‘advice’ in the mass market
should not be treated as a second-tier service. While this model might have
suggested that those investors who could not afford full-scale ‘advice’ be
thrown to the wolves,515 as advice could not otherwise have been provided
under the FSA’s model, it incorporated the allied Generic Advice/Money
Guidance strand.516 But the related commoditization of the investment
product market implied by the blunt advice/sales segmentation risked that
investment products would have become treated as consumer goods and
that empowerment-based information and choice strategies would have
been inappropriately relied on. It also flew in the face of the evidence
that product providers have flawed incentives when it comes to producing
simple, clear and high-performance products which meet investor needs.
Commoditization of this nature also risked that ill-informed and nervous
investors would have simply withdrawn from the investment process in the
absence of, however illusory the quality of the service, some form of advice
or guidance given high dependence on advice. Entirely non-advised sales
are also not likely to have been commercially viable given that investors
need some element of persuasion, which can quickly become characterized
as advice, before they buy a product.517
514
515
516
517
The FSCP argued trenchantly that commission payments should be prohibited for all
forms of advice and argued that Primary Advice would lead to suboptimal outcomes for
large numbers of investors and an unacceptable reduction in standards. It rejected the
implied assumption that investors be classified in terms of the complexity of their advice
requirements and suggested that the independent advice label and an enhanced regulatory
regime might lead to better understanding of advice and its costs.
Industry reaction to this model was hostile, with the British Bankers’ Association arguing
that investors would either have to pay for expensive advice or take important decisions
blind: T. Burgis and A. Felsted, ‘Banks Face Advice Bar in FSA Shake-up’, Financial Times,
30 April 2008. The banking and insurance industry had, however, most to lose from the
loss of the advice label: P. Skypala, ‘FSA Has Chance to Clarify “Sales” and “Advice”’,
Financial Times, Fund Management Supplement, 24 November 2008, p. 6.
2008 RDR Feedback Statement, p. 6.
2008 Interim RDR, p. 25. The industry has expressed concern that investors still need to be
persuaded to buy a product and that non-advised sales, without any additional support,
may not be commercially viable.
284
investment advice and product distribution
Despite the FSA’s preference (and that of many stakeholders) for a
simple advice and sales landscape, following significant criticism518 and
concerns that access to some form of advice would be reduced for less
affluent consumers,519 it revisited the model in its final Feedback Statement in which it proposed a third way. It suggested a distinction between,
first, full-scale ‘independent advice’ and, secondly, a spectrum of ‘sales’
(including ‘non-independent advice’, guided advisory and non-advisory
sales and execution-only sales) which would provide investors with different needs, preferences and financial profiles with a range of services
and with assistance in purchasing products.520 Reflecting empowerment
concerns, the FSA suggested that different forms of ‘advised process’ were
necessary to raise investors’ awareness of their needs, to manage the deterrent effect of long-term products and to ‘encourage’ investors to make
the decision to take action.521 The proposed ‘sales’ spectrum accordingly included a ‘full’ but ‘non-independent’ advice segment which, while
regarded and labelled as a ‘sale’, would be based on a comprehensive review
of investor needs (unlike a straightforward sale),522 be personalized and
reflect equivalent remuneration/adviser charging523 and professionalism
standards524 to those imposed on ‘independent advice’. But, unlike ‘independent advice’, it would be based on a limited range of suitable solutions and so accommodate advice from tied agents and from institutions
advising on proprietary products; the distinction between it and ‘independent advice’ related to the more limited range of products concerned
and not to the degree of adviser professionalism or the extent of the
conflict-of-interest risk from remuneration.525 The ‘sales’ spectrum also
included a ‘guided sale’ segment designed to address the risk of reduced
access to advice services and to provide cost-effective, advice-based solutions for less affluent investors with more straightforward needs.526 Here,
however, the FSA, while supportive, left it to the industry to develop
relevant models, showing some reluctance to develop a discrete regime.527
518
519
522
523
524
527
‘Strong but diverse’ views emerged: 2008 RDR Feedback Statement, p. 17.
Ibid., p. 7. 520 Ibid., p. 55. 521 Ibid., pp. 55–6.
The FSA suggested that, without a personal recommendation, some consumers would be
unwilling to buy or would not identify their savings priorities: ibid., p. 17.
While the model is under development, remuneration structures are to reflect the ‘Adviser
Charging’ principle but, acknowledging the difficulties in delivering full independence
from product providers in the wider ‘sales’ sector (particularly where advice is given by
bank employees on proprietary products), they are to be calibrated to reflect the relevant
incentive risks: ibid., pp. 57–60.
Ibid., pp. 60–1. 525 Ibid., p. 23. 526 Ibid., p. 57.
And generated some nervousness from the FSCP as a result: Press Release, 25 November
2008.
access to mass market advice and the sales problem
285
But it highlighted that the suitability rules which are engaged where
MiFID ‘advice’ is given provide for some flexibility528 while underlining the need for some form of suitability where MiFID ‘advice’ is given.529
The FSA’s objective was not, by contrast with its earlier approach to Basic
Advice, to design these systems; it was more concerned with providing
greater clarity as to how these services would be treated and on liability
risks.530
The FSA’s subsequent June 2009 proposals followed this model
although, reflecting consumer testing of the labelling dynamics, a more
streamlined approach has been adopted. The new regime will be based
on an ‘independent advice’ model and a ‘restricted advice’ model (both
of which can include ‘simplified advice processes’), supported by disclosure requirements. Independent advisers will be required to provide unbiased, unrestricted advice, based on a comprehensive and fair analysis of
the ‘relevant market’, comprising all the retail investment products capable of meeting investor needs and objectives. An adviser charging model
will apply to ‘independent’ and ‘restricted’ advice (calibrated to reflect
advice on proprietary products) – commission-based payments will be
prohibited; enhanced professional standards will also apply to both advice
models. The FSA has also decided to retain the Basic Advice model in
order to support the sale of stakeholder products.
4. The EC and access to advice
How to support mass market access to low-cost, but safe and high-quality,
advice channels which support trusting and empowered investors is probably the most intractable problem faced by retail market policy. But
commission risk and poor access to high-quality advice represent serious threats to retail market efficiency and to retail investor engagement.
They call for action and for the allocation of considerable policy and regulatory resources. The range of levers being pulled in the UK, including the
education-based generic advice/Money Guidance lever, point to the scale
of the challenge and the resources demanded.
Sophisticated education strategies might cut a path through the impasse.
Many of the key messages which advice should deliver to vulnerable and
inexperienced investors (such as with respect to debt repayment and the
528
529
‘[S]uitability is a flexible standard, determined with reference to the nature and extent
of the service provided . . . [T]here is scope for firms to design simplified advice processes . . . capable of meeting the suitability requirement’: ibid., p. 64.
Ibid., pp. 61–4 and Annex 8. 530 Ibid., p. 6.
286
investment advice and product distribution
costs of investing) will always be difficult to deliver through suitability/fair treatment obligations, given the profit-maximization incentives
which drive rational investment firms. Outsourcing the educative aspects
of advice to the distribution and advice sector raises the risk that key
messages are not delivered. As discussed in chapter 7, more imaginative
(and costly) solutions as to how to deliver generic advice, whilst not on the
scale of the UK model, may be required, although here the EC’s powers
are limited.
MiFID’s conceptualization of ‘investment advice’, its support of generic
advice and the flexibility of the suitability regime may support the incubation of innovative, low-cost, local responses to the access and commission
risk problems and to the sales/advice conundrum; EC resources would
be well directed to the encouragement of imaginative solutions and the
sharing of best practices. But MiFID does not provide for the weakening of protections where ‘advice’ comes within its definition of ‘investment advice’ in the form of a personal recommendation. The FSA has
acknowledged the restrictions MiFID places on its reforms;531 although
the FSA has the freedom to impose new, lighter rules on ‘Article 3 firms’, it
does not have this freedom with MiFID firms, typically banks and larger
investment firms. The EC shackle may not necessarily be a bad thing;
EC restrictions, in part, led to the FSA’s adoption of a more nuanced
advice and sales distinction532 and the prevalence of commission risk and
limited investor competence suggest that great caution is required before
suitability protections are disabled. But the core suitability requirement
and its activation on a personal recommendation does, nonetheless, limit
the extent to which low-cost, non-advised models can be safely used by
firms.533 The risk remains that MiFID will inhibit the development of
the imaginative advice and distribution structures ‘in action’ required to
support trusting and empowered investors. The fit between MiFID and
low-cost advice, and how regulators and the industry can be supported
in developing high-quality but low-cost advice models, might, accordingly, be better preoccupations for the Commission than the massive
531
532
533
2007 RDR, p. 75; 2008 RDR Feedback Statement, pp. 63–4; and Consultation Paper No.
09/18, p. 6.
2008 RDR Feedback Statement, p. 18.
Considerable caution is evident in the FSA’s discussion of decision trees in its 2008 RDR
Feedback Statement, which warned firms of the need to be alert to providing personal
recommendations and to avoid providing any judgment on the suitability of investments:
Annex 7, p. 4.
access to mass market advice and the sales problem
287
re-engineering of the selling regulatory regime envisaged in the Packaged
Products Communication. But it appears that rules ‘on the books’ and
the easier challenges of ensuring regulatory tidiness across the substitute
products sector have greater appeal than the difficult challenges and wide
range of strategies associated with ensuring access to high-quality advice ‘in
action’.
5
Disclosure
I. Disclosure and EC investor protection
1. The retail market disclosure regime
Disclosure, with its ‘self-help’ connotations, is strongly associated with the
empowerment model. It forms a central element of current retail market
policy internationally, reflecting the ingrained assumption that disclosure
can support better decision-making and stronger market-based saving;1
this assumption is evident in the UK regime by the FSA’s placing of clear
information at the heart of its Treating Customers Fairly initiative2 and of
its regulatory and supervisory strategies generally.3
The post-FSAP EC retail market disclosure regime for the intermediated and product-based transactions which strongly characterize the EC
retail market has two dimensions: investment products; and investment
services. Product disclosure is primarily a function of the UCITS regime.4
But it is also addressed by MiFID’s5 disclosure requirements for the ‘financial instruments’ in respect of which investment services are provided,
1
2
3
4
5
S. Tanner, The Role of Information in Savings Decisions, Briefing Note 7 (London: Institute
for Fiscal Studies, 2000) in the UK context; and, in the EC context, BME Consulting, The EU
Market for Consumer Long-Term Retail Savings Vehicles: Comparative Analysis of Products,
Market Structure, Costs, Distribution Systems, and Consumer Savings Patterns (2007) (‘BME
Report’), p. 174. An extensive US scholarship highlights the prevalence of ‘more disclosure’
as a retail market technique: for example, D. Langevoort, The SEC as a Lawmaker: Choices
about Investor Protection in the Face of Uncertainty (2006), ssrn abstractid=947510; and
H. Jackson, ‘Regulation in a Multi-Sectored Financial Services Industry: An Exploration
Essay’ (1999) 77 Washington University Law Quarterly 319.
Financial Services Authority (FSA), Good and Poor Practices in Key Features Documents
(2007), p. 5.
Clear, simple and understandable information is a core element of FSA’s current retail market
strategy: C. Briault, Speech on ‘The FSA’s Retail Strategy’, 27 February 2008, available via
www.fsa.gov.uk/Pages/Library/Communications/Speeches/index.shtml.
Council Directive 85/611/EEC of 20 December 1985 on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in
transferable securities, OJ 1985 No. L375/3.
Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on
markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC
288
disclosure and ec investor protection
289
and by the Prospectus Directive, 6 particularly with respect to structured
securities but also with respect to direct investments and execution-only
sales generally.7 Services disclosure is governed by the Distance Marketing of Financial Services Directive8 and MiFID, which address marketing communications, pre-contractual and pre-service disclosure and
best execution disclosure. Disclosure is, however, employed across MiFID;
execution-only services, for example, can be offered only with respect to
‘non-complex’ products, which determination depends in part on whether
‘adequately comprehensive’ information is available such that the ‘average
retail investor’ can make an informed judgment about the product (MiFID
Level 2 Directive, Article 38(d)).
The informed and empowered investor is a recurring feature of EC disclosure rhetoric9 and a persistent motif of the FSAP disclosure regime10
6
7
8
9
10
and Directive 2000/12/EC of the European Parliament and of the Council and repealing
Council Directive 93/22/EEC, OJ 2004 No. L145/1 (‘MiFID’); and European Commission
Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating
conditions for investment firms and defined terms for the purposes of that Directive, OJ
2006 No. L241/26 (‘MiFID Level 2 Directive’).
Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003
on the prospectus to be published when securities are offered to the public or admitted to
trading and amending Directive 2001/34/EC, OJ 2003 No. L345/64 (‘Prospectus Directive’).
It is supported by ongoing issuer disclosure requirements under the Market Abuse
and Transparency Directives: European Parliament and Council Directive 2003/6/EC of
28 January 2003 on insider dealing and market manipulation, OJ 2003 No. L96/16 (‘Market
Abuse Directive’); and Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the harmonisation of transparency requirements in relation to
information about issuers whose securities are admitted to trading on a regulated market
and amending Directive 2000/34/EC, OJ 2004 No. L390/38 (‘Transparency Directive’) (see
further ch. 6).
European Parliament and Council Directive 2002/65/EC of 23 September 2002 concerning the distance marketing of consumer financial services and amending Council Directive 90/619/EEC and Directives 97/7/EC and 98/27/EC, OJ 2002 No. L271/16 (‘Distance
Marketing Directive’, or DMD).
E.g. European Commission, Communication on Article 11 (COM (2000) 722), p. 16; Green
Paper on Retail Financial Services (COM (2007) 226), p. 3; and White Paper on Financial Services 2005–2010 (COM (2005) 629), p. 7. The European Parliament has called for ‘succinct
consumer-friendly information’ (European Parliament, Resolution on Financial Services
Policy (2005–2010) White Paper (P6 TA(2007)0338, 2007) (‘Van den Burg II Resolution’)
para. 39) and highlighted information as ‘essential to empowering investors’ (Resolution
on Asset Management (P6 TA-PROV(2007)0627, 2007) (‘Klinz II Resolution’), para. 11).
The Prospectus Directive, for example, is designed to support ‘informed assessment’ by
investors (Art. 5), the DMD is designed to allow the consumer to ‘properly appraise’
the financial service and ‘make an informed choice’ (recital 21), the UCITS Directive
disclosures should allow an investor ‘to make an informed judgment of the investment
290
disclosure
and ancillary consumer protection measures, notably the Unfair Commercial Practices Directive.11 The assumption under-cutting the regime,
at least until the recent UCITS reforms, has been that the retail investor
is essentially rational, willing to decode disclosure, receptive of regulatory
efforts to increase the volume, and improve the clarity, of disclosure and,
when armed with appropriate disclosure, able to navigate an expanding
universe of products and service and to exert market discipline.12 The
weight of expectation placed on the retail investor is evidenced across the
disclosure regime and the policy rhetoric, including the repeated references to disclosure being provided in advance of the purchase/investment
decision,13 the need for disclosure to be clear and understandable14 and the
troublesome assumption that disclosure supports comparability, informed
choice and investor disciplining of services and products.15
2. The investor understanding problem
a) Investor understanding
Disclosure has considerable attractions as a retail market tool. Poor information has been associated with higher participation costs and low levels
of market engagement.16 Disclosure interferes only to a limited extent with
the autonomy of the investment firm and the investor.17 It can empower
11
12
13
14
15
16
17
proposed . . . and . . . of the risks’ (Art. 28), while MiFID is directed to investors being
‘reasonably able to understand the nature and risks’ and able to ‘take investment decisions
on an informed basis’ (Art. 19(3)).
The Directive’s ‘average consumer’ concept assumes a consumer ‘who is reasonably wellinformed and reasonably observant and circumspect, taking into account social, cultural
and linguistic factors’: Directive 2005/29/EC of the European Parliament and of the Council
of 11 May 2005 concerning unfair business-to-consumer commercial practices in the
internal market, OJ 2005 No. L149/22, recital 18.
The EC is not alone in this regard. E.g. A. Palmiter and A. Taha, Mutual Fund Investors:
Divergent Profiles (2008), ssrn abstractid=1098991, in the context of US mutual fund
disclosure.
MiFID Level 2 Directive, Art. 29; DMD, Art. 3; and UCITS Directive, Art. 33.
E.g. Prospectus Directive, Art. 5(1) and (2); UCITS Directive, Art. 28; and MiFID,
Art. 19(2).
European Commission, White Paper on Enhancing the Single Market Framework for Investment Funds (SEC (2006) 1451), para. 2.
E.g. B. S´ejourn´e, Why Is the Behaviour of French Savers So Inconsistent with Standard Portfolio
Theory? (AMF Working Papers, 2006).
G. Howells, ‘The Potential and Limits of Consumer Empowerment by Information’ (2005)
32 Journal of Law and Society 349; and J. Benjamin, Financial Law (Oxford: Oxford
University Press, 2007), p. 233.
disclosure and ec investor protection
291
investors to achieve their investment objectives18 and support regulatory
efficiencies by accommodating asymmetric investor ability.19 It can mitigate regulatory risks; the risks of interventionist product regulation, for
example, can be mitigated by disclosure.20 In the EC context, it can generate less political tension than firm-facing rules which may disrupt national
markets and business models.21
But disclosure is not, in itself, an objective of retail market regulation, despite the ever-increasing volume of regulated information. Retail
market disclosure is a means whereby investors overcome an informationasymmetry-based market failure22 to make informed and effective decisions, monitor market actors and drive the production of products and
services which meet their needs. Unlike issuer disclosure, which has systemic, market efficiency dynamics, retail market disclosure is addressed to
individual decision-making.23 But effective disclosure design for the retail
markets, and particularly for the expanding universe of complex investment products, represents one of the most intractable of retail market
problems.24
Behavioural finance suggests that the biases and competence failures which dog investor decision-making are unlikely to be dealt with
through disclosure. The over-confidence bias, for example, suggests that
retail investors can be overly credulous and not sufficiently sceptical of
18
19
20
21
22
23
24
E. Tafara and R. Peterson, ‘A Blueprint for Cross-Border Access to US Investors: A New
International Framework’ (2007) 48 Harvard International Law Journal 31.
C. Camerer, S. Issacharoff, G. Loewenstein, T. O’Donoghue and M. Rabin, ‘Regulation for
Conservatives: Behavioral Economics and the Case for “Asymmetric Paternalism”’ (2003)
151 University of Pennsylvania Law Review 1211.
By contrast with the UCITS regime, US retail mutual fund regulation allows greater freedom
to the fund. It imposes general diversification requirements where funds are marketed as
‘diversified’ but otherwise relies on disclosure.
S. Weatherill, EU Consumer Law and Policy (2nd edn, Cheltenham: Edward Elgar, 2005),
p. 85.
‘[A]rguments in favour of transparency are often framed in the context of the retail markets, where information asymmetry between consumers and firms can lead to dysfunctional markets and outcomes’: FSA, Transparency as a Regulatory Tool (Discussion Paper
No. 08/3, 2008), p. 4.
R. Gilson and R. Kraakman, ‘The Mechanisms of Market Efficiency Twenty Years Later:
The Hindsight Bias’ (2003) 28 Journal of Corporation Law 715.
The financial crisis has, of course, also exposed the inadequacies of market monitoring
and disclosure in the wholesale markets: E. Avgouleas, What Future for Disclosure as a
Regulatory Technique? Lessons from the Global Financial Crisis and Beyond? (2009), ssrn
abstractid=1369004; and S. Schwarcz, ‘Disclosure’s Failure in the Subprime Mortgage
Crisis’ (2008) Utah Law Review 1109.
292
disclosure
disclosure.25 Disclosure may not be able to address framing effects. The
confirmation bias suggests that information which conflicts with prior
assumptions may be discounted. The anchoring effect suggests that common anchors, such as past performance information, are likely to be
over-relied on.26 Oral communications are likely to be considerably more
effective than written communications27 – notwithstanding the resources
poured into the design of written disclosures. The problem of information
overload has been well documented,28 if sometimes contested.29 Labels
pose particular problems;30 investors are, for example, inclined to judge
risk based on thoughts associated with the label, rather than with reference
to underlying exposures.31
b) The evidence
A growing body of empirical evidence suggests that retail-market-oriented
disclosure struggles to enhance the investor decision. The 2006 French
TNS-Sofres report32 into mandatory disclosures found that small investors
had only limited awareness of mandatory disclosures, finding them technical and inaccessible, often alarmist, too long, austere and inadequate in
prioritizing key risks. It also bore out the intuition that different investor
groups, with different risk profiles, react differently to disclosure,33 which
compounds the difficulties faced by domestic regulators, and the EC,
in designing disclosure for the elusive ‘average investor’. The FSA has,
25
26
27
28
29
30
31
32
33
R. Deaves, C. Dine and W. Horton, How Are Investment Decisions Made?, Research Study
prepared for the Task Force to Modernize Securities Legislation in Canada (2006) (‘Deaves
Report’), p. 262.
J. Gray and J. Hamilton, Implementing Financial Regulation: Theory and Practice (Chichester: John Wiley & Sons, 2006), pp. 207–8 (summarizing the impact of biases).
R. Prentice, ‘Whither Securities Regulation? Some Behavioral Observations Regarding
Proposals for Its Future’ (2002) 51 Duke Law Journal 1397.
T. Paredes, ‘Blinded by the Light: Information Overload and Its Consequences for Securities
Regulation’ (2003) 81 Washington University Law Quarterly 417.
D. Grether, A. Schwartz and L. Wilde, ‘Irrelevance of Information Overload: An Analysis of
Search and Disclosure’ (1985–6) 59 Southern California Law Review 277; and R. Romano,
‘A Comment on Information Overload, Cognitive Illusions, and Their Implications for
Public Policy’ (1986) 59 Southern California Law Review 313.
See further ch. 3.
L. Koonce, M. Gascho Lipe and M. McAnally, Judging the Risk of Financial Instruments:
Problems and Potential Remedies (2004), ssrn abstractid=557863.
TNS-Sofres, Report for the AMF, Investigation of Investment Information and Management
Processes and Analysis of Disclosure Documents for Retail Investors (2006) (‘TNS-Sofres
Report’).
Ibid., p. 6. The FSA has highlighted similar difficulties: FSA, Financial Risk Outlook 2007,
p. 81.
disclosure and ec investor protection
293
from its establishment,34 and reflecting a long-standing UK disclosure
preoccupation,35 engaged in extensive research on its retail market product disclosures; MiFID implementation has intensified these efforts.36
The FSA has focused primarily on the ‘packaged product’ regime and the
requirement since 1994 that a Key Features Document (KFD) be prepared
by product providers and distributed by those selling packaged products (section III below). As discussed in section II below, the tidal wave of
research is ultimately doubtful as to the KFD’s impact on investor decisionmaking. In a revealing finding, the FSA has also found that retail investors
associate the FSA and regulation with the prevention of mis-selling and
sales practices, rather than with disclosure.37
The FSA’s research and the TNS-Sofres Report are located in the investor
experience in two different markets and provide only a snapshot of investor
reaction. But they, and the assumptions of behavioural finance, certainly
suggest that the post-FSAP EC disclosure regime, which now dictates
product and investment firm disclosure, to a very large extent, across
the Member States, is required to do some very heavy lifting in both
protecting and empowering investors, as seems to be borne out by the
slowly emerging, pan-EC empirical evidence. The 2005 Eurobarometer
on financial services found that only 15 per cent of respondents agreed
that the information from financial institutions was clear and understandable.38 The 2008 Optem Report examined reaction to pre-contractual
34
35
36
37
38
E.g. Informed Decisions? How Consumers Use Key Features: A Synthesis of Research on the
Use of Product Information at the Point of Sale (Consumer Research No. 5, 2000).
J. Black, Rules and Regulators (Oxford: Oxford University Press, 1997), p. 183.
Including: FSA, Services and Costs Disclosure – Stage 3: Qualitative Research – Mock Sales
Testing (Consumer Research No. 65c, 2008); FSA, Services and Costs Disclosure – Stage 2:
Qualitative Research with Potential and Recent Purchasers of Financial Products (Consumer
Research No. 65b, 2008); and FSA, Services and Costs Disclosure – Stage 1: Qualitative
Research with Potential and Recent Purchasers of Financial Products (Consumer Research
No. 65a, 2008).
In 2008, only 10 per cent of those canvassed associated the FSA with information, while
28 per cent and 44 per cent associated the FSA with preventing mis-selling and ensuring
fair treatment: FSA, Consumer Awareness of the FSA and Financial Regulation (Consumer
Research No. 67, 2008), pp. 9–10.
European Commission, Special Eurobarometer No. 203, Public Opinion in Europe on Financial Services: Summary (2005), p. 17 (the survey did not require participants to respond to
all statements in the survey, so it cannot be safely assumed that 85 per cent were unhappy
with disclosures). An earlier survey found that 58 per cent of respondents disagreed with
the statement that information was clear and understandable (European Commission, Special Eurobarometer No. 202, Public Opinion in Europe: Financial Services: Highlights (2004),
p. 12).
294
disclosure
investment disclosure,39 based on survey evidence from groups of
consumers with some experience with investment products and from
groups of inexperienced consumers, in all the Member States. Overall, attitudes to information ‘were marked by widespread distrust and
dissatisfaction’, although investors were generally happier with information levels than consumers of financial services generally. Those more
conservative investors who dominate in the EC market (typically consumers of investment products which the Report characterized as prudent
‘savers’) found disclosures to be complicated, obscure, complex, incomplete, often designed as marketing rather than information documents
and insufficiently focused on risk; they relied on advice rather than on
personal assessment of disclosure. More experienced and risk-tolerant
investors, characterized by the Report as ‘gamblers’, had fewer difficulties,
although they tended to gather information independently and from a
wide range of sources. The third category, the inexperienced consumers
who are critical to any attempts to promote stronger market savings, found
disclosures complex and difficult to understand. Despite the focus of the
EC regime on published disclosures, the Report also found that face-toface or telephone contact was preferable to written disclosures.
c) Comparability
The link between disclosure, informed decision-making and comparability is particularly troublesome. Reflecting the empowerment model,
greater comparability and informed choice are often associated with
retail market disclosure internationally, and with product disclosure
reform in particular.40 This link has particular resonances in the EC given
the association between choice, competition and market integration.
But comparability demands much of the retail investor. Typically, the
retail investor struggles in making an informed comparison, as has been
highlighted in a series of FSA studies41 and by the Optem Report, which
found that comparisons were difficult to make and that investors were
39
40
41
Optem, Pre-contractual Information for Financial Services: Qualitative Study in the 27 Member States (2008) (‘Optem Report’) (it also considered other financial services disclosure).
Comparability is, for example, one of ASIC’s ‘Good Disclosure Principles’, the 2008 SEC
reforms concerning mutual fund interactivity data are designed to support comparability
(SEC, Press Release 2008-94, available via www.sec.gov/news/press/2008/) and the Dutch
AFM’s ‘Financial Leaflet’ regime is designed to support comparability (AFM, A Quantitative
Risk Indicator for Financial Products (2007), p. 5).
Including FSA, Levels of Financial Capability in the UK: Results of a Baseline Survey (Consumer Research No. 47, 2006), pp. 96–100 (finding that less than 50 per cent of those
surveyed collected information from more than one company and that only 7 per cent
disclosure and ec investor protection
295
‘overwhelmed’ by the range of ‘increasingly numerous and confusing’
offers available.42 The FSA, with considerable experience in the retail
product market, has appeared sceptical as to the ability of product
disclosures to support comparability,43 although it remains an important
element of its product disclosure strategy;44 in particular, with its 2008
MiFID-related reforms to its firm services and costs disclosure regime, the
FSA appears to favour clarity and firm flexibility over standardization and
comparability.45 The comparability assumption appears entrenched, however, in the EC’s UCITS regime. The UCITS IV disclosure reform process
saw some initial cooling of enthusiasm for comparability as an objective
of the new regime and, by implication, a lightening of the load placed
on the retail investor. The Commission’s May 2006 summary prospectus
workshop, for example, acknowledged that immediate comparability
between CISs, and a search for absolute uniformity of content and format,
would be a ‘fool’s errand’, that a distinction was required between support
of investor understanding and support of comparability and that investor
understanding was the priority for UCITS disclosure.46 But the UCITS
IV Proposal,47 and its adoption of the new Key Investor Information
(KII) model, is firmly anchored to comparability and empowerment.48
42
43
44
45
46
47
48
bought products on the basis of a ‘best buy’) and Consumer Perceptions of Basic Advice
(Consumer Research No. 70, 2008) (finding that retail investors found the limited range of
products sold under Basic Advice to be an advantage (p. 7)).
Even more experienced investors tended to compare only two or three products.
FSA, Consumer Research No. 5, p. 14; and FSA, Informing Consumers at the Point of Sale
(Consultation Paper No. 170, 2003), pp. 44–5.
The UK’s MiFID Article 4 application to retain its KFD product-disclosure requirements
argued that standardization of format and content was necessary to minimize the risk
of a lack of comparability between substitute products: HM Treasury, Notification and
Justification for Retention of the FSA’s Requirements on the Use of Dealing Commissions
under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC and Notification
and Justification for Retention of Certain Requirements Relating to the Market for Packaged
Products under Article 4 of Directive 2006/73/EC Implementing Directive 2004/39/EC (2007)
(‘UK Article 4 Application’), p. 20.
FSA, Simplifying Disclosure: Information about Services and Costs – Feedback on CP0/3 and
Final Handbook Text (Policy Statement No. 08/7, 2008).
European Commission, Simplified Prospectus Workshop. Summary of the First Meeting of
15th May 2006 (2006) (‘May 2006 Workshop’), pp. 1 and 10.
References to the reform (the ‘UCITS Recast’ or ‘UCITS IV’) are to the European Parliament
text: European Parliament, Legislative Resolution of 13 January on the Proposal for a Directive
of the European Parliament and of the Council on the co-ordination of laws, regulations and
administrative provisions relating to undertakings for collective investment in transferable
securities (2009) (P6 TA-PROV(2009)0012, 2009).
European Commission, Impact Assessment of the Legislative Proposal Amending the UCITS
Directive (SEC (2008) 2236), pp. 30–1 and 34.
296
disclosure
The substitute product debate saw the Commission acknowledge the
limitations of disclosure and the doubtful benefits of efforts to promote
comparability across the universe of investment products.49 But comparability has re-emerged as an objective in its April 2009 proposals to
reform the disclosure regime for packaged products (section III below).
3. The risks of disclosure
The demand-side, investor-facing aspect50 of disclosure presents regulators who seek to empower investors through information with a
formidable, and perhaps insurmountable, challenge51 given poor decisionmaking52 and an ever more complex product market.53 And, even
where strenuous efforts are expended in the attempt to deliver effective disclosure, it does not follow that decision-making will be optimal.54
Responsibilization strategies which place more responsibility for savings
and for risk monitoring on the investor, and which regard disclosure not
only as a means of addressing information asymmetries but also as a technique for inculcating certain values,55 become highly troublesome.56 And,
even if some degree of investor competence could be assumed, or even
delivered through regulatory reform, the ability of retail investors to monitor and discipline firms on the basis of disclosure is doubtful given the
severe difficulties they face in seeking redress, particularly cross-border.
49
50
51
52
53
54
55
56
European Commission, Minutes of the Industry Workshop on Retail Investment Products
(2008), p. 8.
Disclosure has been characterized in terms of the demand side (interpretation) and the
supply side (production and distribution): J. Macey, ‘A Pox on Both Your Houses: Enron,
Sarbanes–Oxley and the Debate Concerning the Relative Efficiency of Mandatory Versus
Enabling Rules’ (2003) 81 Washington University Law Quarterly 329.
A. Schwartz and L. Wilde, ‘Intervening in the Market on the Basis of Imperfect Information:
A Legal and Economic Analysis’ (1978–9) 127 University of Pennsylvania Law Review 630.
Gray and Hamilton, Implementing Financial Regulation, pp. 212–15 (critiquing FSA reliance
on disclosure). In the EC context, it has been queried whether EC reliance on disclosure
may mask substantial unfairness in the bargaining process: Weatherill, EU Consumer Law
and Policy, p. 85.
S. Claessens, Current Challenges in Financial Regulation (2006), ssrn abstractid=953571,
pp. 21–2.
J. Rachlinski, ‘The Uncertain Psychological Case for Paternalism’ (2003) 97 Northwestern
University Law Review 1165, 1177, suggesting that information and warnings are ‘useless’
if individuals make bad choices even in possession of good information.
T. Williams, ‘Empowerment of Whom and for What? Financial Literacy Education and the
New Regulation of Consumer Financial Services’ (2007) 29 Law and Policy 226; and Gray
and Hamilton, Implementing Financial Regulation, pp. 49–50.
It has been highlighted that responsibilization strategies can make ‘heroic assumptions’ as
to investor ability: I. Ramsay, ‘Consumer Law, Regulatory Capitalism and the New Learning
in Regulation’ (2006) 28 Sydney Law Review 9, 13.
disclosure and ec investor protection
297
The considerable industry and regulatory resources expended on disclosure may therefore be misallocated57 at a time when regulation is under
intense pressure from market turbulence and innovation, and given the
demands of managing a cohort of novice investors and meeting the public
policy expectation of wider market engagement.
The assumption that disclosure can be used effectively by investors can
lead to more specific regulatory design failures. Comparability difficulties,
for example, are more likely to be addressed by industry58 or regulatory59
comparative search mechanisms, than by investors corralling and comparing mandated disclosures; information overload and product complexity
can quickly lead to the rational response being not to exert choice given
the costs of comparison.60 A key design question accordingly relates to
whether disclosures provide information which is easily incorporated by
these search mechanisms; the inconsistent requirements applied to UCITS
and other substitutable investment products, to take a current example,
limits the development of comparability tables.61
Industry compliance remains a formidable challenge, as is clear from
the FSA’s experience;62 in 2008, the FSA warned that problems persisted
with communications and disclosure generally, leading to the risk of
investors being misled.63 The French AMF has also struggled with ensuring
effective disclosure practice64 as has the Dutch AFM65 and CONSOB.66 The
57
58
59
60
61
62
63
64
65
66
‘The . . . image of the investor bound up in a web of cognitive illusions and processing
deficiencies, with little appetite for the truth, offers the discouraging possibility that many
traditional strategies of investor protection may not be worth the cost’: D. Langevoort,
‘Theories, Assumptions and Securities Regulation: Market Efficiency Revisited’ (1992) 140
University of Pennsylvania Law Review 851, 912.
Such as the Morningstar website which rates different funds.
Such as the FSA’s Comparative Tables which provide comparative disclosures on a range
of investment and savings products.
Grether, Schwartz and Wilde, ‘Irrelevance’, 277.
A point made by the admittedly partisan European Fund and Asset Management Association (EFAMA) during recent Commission consultations: European Commission, Minutes
of the Industry Workshop on Retail Investment Products (2008), p. 4.
FSA, Treating Customers Fairly: Measuring Outcomes (2007), pp. 14–15, noting poor compliance with TCF obligations with respect to the Key Features Document and marketing
promotions.
In its 2008 Financial Risk Outlook, the FSA warned that it was still seeing problems with
communications and disclosure: Financial Risk Outlook 2008, p. 48.
One survey revealed that only one in eight retail investors advised on fund investments
received a fund prospectus: TNS-Sofres Report, p. 16.
It has reported that the required Financial Information Leaflet was only provided for 8 per
cent of complex products, in 30 per cent of cases no leaflet was provided and that Leaflets
misrepresented costs, risks and returns: AFM, Annual Report 2006, pp. 52–3.
A survey of split-capital UCITS marketed in Italy found that disclosure was often incomplete and not sufficiently comprehensible: C. Bracaloni, M. Antinarella, F. Martiniello and
298
disclosure
difficulties are all the greater given the adoption by MiFID of a principlesbased model for disclosure and the strains this places on supervision and
enforcement.
Reliance on disclosure may also mask the need for more radical firmfacing measures and for robust ‘law in action’ strategies, particularly with
respect to deepening incentive risks in the product and advice market and
when regulators face well-organized industry lobbies and the retail voice is
muted. While structured and alternative investment products, for example,
offer the benefits of potentially higher returns and sophisticated diversification techniques, disclosure is a very limited tool for dealing with the risks
they pose to investors, which are likely to be better dealt with through the
firm-facing and/or product rules which pose difficult design challenges.
Harmonization injects further risks given wide variations in investor
competence and experience, different degrees of retail investor trust in
regulated disclosures, and divergences in how investors respond to different formats. Although the BME and Optem Reports point to common
decision-making failures, evidence thus far is largely based in local markets; the Eurobarometer studies point to varying levels of satisfaction with
disclosure across the Member States.67 Developing a disclosure template
for the notional ‘average EC investor’ remains a challenge, even allowing
for CESR’s capacity, in combination with the cross-sector 3L3 committees,
CEBS and CEIOPS, to capture national regulatory expertise and market
evidence, although the KII experience is heartening (section II below).
The risks are increased by the limitations which harmonization may place
on Member States’ ability to experiment with different disclosure formats
and to respond to local risks.
Some scepticism as to the value of disclosure as a retail market tool
has become a feature of the UK regime. Although its efforts to improve
investor understanding and processing of disclosure ‘in action’ are intensifying, the FSA appears to be withdrawing somewhat from heavy reliance
on disclosure in the retail markets. While the unenthusiastic position of
the FSA’s Financial Services Consumer Panel (FSCP) towards disclosure
is not surprising,68 the FSA appears increasingly to appreciate the limits
67
68
T. Marcelli, Survey on Disclosure and Correctness of Behaviour in Marketing Classes of Units
and Shares of Harmonised UCITS in Italy (CONSOB Quaderno No. 60, CONSOB, 2007).
The 2004 Study reported that, while 64 per cent, 66 per cent and 67 per cent of French,
Italian and Swedish respondents, respectively, did not agree that information provided was
clear and understandable, 44 per cent of Luxembourg respondents, 46 per cent of Finnish
respondents and 44 per cent of Belgian and Irish respondents did: European Commission,
Special Eurobarometer No. 202, p. 12.
The Panel has criticized the FSA where regulatory solutions have increased the understanding burden placed on consumers, but where consideration has not been given to whether
disclosure and ec investor protection
299
of disclosure, particularly in those policy areas currently outside the reach
of the EC regime and where some flexibility exists.69 Its 2005 review of
the treatment of ‘bundling’ and ‘softing’ conflict-of-interest risks in the
execution process, and with respect to collective investment, for example,
saw the FSA acknowledge that disclosure was a very limited tool in dealing
with the conflicts-of-interest risks faced by retail investors.70 It proposed
instead an innovative model based on CISs being required to appoint
an ‘investors’ representative’ who would monitor disclosure, engage with
the CIS and report to investors.71 Its 2005 review of whether its nonUCITS CIS regime (the ‘NURS’ regime) should be recast to incorporate
wider range (alternative investment) products also saw some concern as to
the effectiveness of disclosure,72 while the related extension of the NURS
regime to accommodate funds-of-hedge-funds saw the FSA rely more
heavily on manager-facing controls than on disclosure requirements.73
The FSA’s recent approach to substitute product risk also reveals some
scepticism as to disclosure and a concern that the effectiveness, rather than
the breadth, of disclosure be considered in any EC policy response.74 The
radical attempts by the FSA to reform the advice and distribution regime
through predominantly supply-side reforms under the Retail Distribution
69
70
71
72
73
74
consumers can manage this burden: Financial Services Consumer Panel (FSCP), Annual
Report 2004–2005, p. 16.
‘We have to acknowledge the findings from many of our reviews of the retail market which call into question how far traditional regulatory tools such as disclosure can
really help consumers make sensible, informed decisions’: C. Briault, FSA, Speech on
‘Regulatory Developments and the Challenges Ahead’, 30 January 2008, available via
www.fsa.gov.uk/Pages/Library/Communications/Speeches/index.shtml.
FSA, Bundled Brokerage and Soft Commission Arrangements for Retail Investment Funds
(Consultation Paper No. 05/13, 2005), p. 8.
Ibid., pp. 10–18. The FSA ultimately adopted a self-regulation model and ‘strongly encouraged’ firms to promote the representative model: FSA, Bundled Brokerage and Soft Commission Arrangements for Retail Investment Funds: Feedback Statement (Policy Statement
No. 06/5, 2006), p. 4.
The FSA queried whether disclosure could be provided on risks and outcomes in a manner which investors would understand and highlighted the importance of investability
thresholds, conduct-of-business rules and product regulation in protecting investors: FSA,
Wider Range Retail Investment Products: Consumer Protection in a Rapidly Changing World
(Discussion Paper No. 05/3, 2005), p. 25.
Although the FSA emphasized the importance of clear disclosures, it also noted the limitations of disclosure for opaque and complex products, particularly given low financial
capability, and focused on manager-facing strategies: Funds of Alternative Investment Funds
(Consultation Paper No. 08/4, 2008), p. 12.
FSA, Response to the European Commission’s Call for Evidence on Need for a Coherent
Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail
Investment Products (2008) (‘FSA Substitute Products Response’), p. 13.
300
disclosure
Review (RDR) also suggest an acceptance of the limits of disclosure,75 as
might the strenuous efforts being expended on the Treating Customers
Fairly regime. Disclosure, rather than prescriptive asset allocation rules,
has, however, been relied on in the FSA’s recent review of the listing rules
for listed investment trusts;76 prescriptive asset allocation rules have been
removed in favour of governance/board independence requirements and
high-level transparency requirements.77 This disclosure-centric approach
reflects, however, the institutional market in which trusts partly operate,78
and the roots of the investment trust regime in company law and its
disclosure requirements, rather than in retail-market-focused product
regulation.79 Disclosure is also central to the FSA’s recent discussion of
how greater transparency can be used as a supervisory tool, but the FSA
addressed the costs and risks of disclosure as well as its benefits, warning
that disclosure was not a panacea for all market failures.80
4. Disclosure ‘in action’
But disclosure is not without merit. The engaged but vulnerable trusting investor who requires support in navigating the financial markets
is not entirely irrational, has the capacity to learn and should be supported in becoming empowered and independent. Disclosure is central to long-term efforts to improve investor decision-making81 and to
the appearance of a truly empowered investor. FSA evidence, for example, points to disclosure’s potential to enhance understanding of investment product charges.82 Demand-side disclosure strategies also carry the
long-term promise of reducing the risks of more direct intervention in the
75
76
77
78
79
80
81
82
While the RDR includes a labelling of advice services element, the FSA has acknowledged
that ‘disclosure alone may be insufficient to ensure good consumer outcomes’: Retail
Distribution Review (Feedback Statement No. 08/6, 2008), p. 25.
FSA, Investment Entities Listing Review (Consultation Paper No. 07/12, 2007).
FSA, Listed Investment Entities Review (Consultation Paper No. 06/21, 2006).
Although the FSA highlighted the importance of its proposals for the retail sector given that
‘retail investment in listed investment entities totals many billions of pounds’: Consultation
Paper No. 06/21, p. 4.
Where investment trusts have a regular savings component, and thus a more direct retail
market link, they are subject to the KFD requirement, but only 10,000 of the 844,000
investments sold in 2007–8 took this form: FSA, Retail Investments Product Sales Data
Trends Report September 2008 (2008), p. 8.
FSA, Transparency as a Regulatory Tool (Discussion Paper No. 08/3, 2008).
Camerer et al., ‘Regulation for Conservatives’, 1233.
CRA International, Benefits of Regulation: Effect of Charges Table and Reduction in Yield
(2008) (‘2008 CRA Report’). The research into the impact of the FSA’s requirement that
investment product disclosure include a Reduction in Yield figure and an Effect of Charges
disclosure and ec investor protection
301
retail markets83 and of easing the severe pressure which must, by necessity,
be placed on advice and distribution regulation.
Persistence is required.84 But the focus must be on disclosure ‘in action’
and on ‘processability’85 rather than on expanding and refining disclosure ‘on the books’. Rather than despairing as to the irrationality of the
decision-making process, regulators should embrace its complexity;86 the
dominant short-cuts used in complex decision-making environments can,
for example, be applied.87 Perseverance is required with labelling, format
and design strategies. Practical reforms might include more attention to
the time at which disclosure is provided; although variants of the ‘in good
time’ formula are used across the directives, in practice disclosures are
likely to be provided simultaneously with contract conclusion. Online
disclosures require more attention, particularly if comparability is to be
achieved. Clearly, design must not occur in a vacuum; much more careful
testing of disclosure, the consolidation (and encouragement of the collection) of evidence from different local markets, and pan-EC studies on the
lines of the 2007 BME Report and the 2008 Optem Report are all required.88
Design must also be linked to the achievement of identified and
enhanced decision-making outcomes.89 The question is not simply
whether the investor understands the disclosure. The key question is
whether disclosure supports the investor in making an optimum investment decision. While the investment decision is highly personalized, the
83
84
85
86
88
89
Table (n. 232 below) showed that 6–15 per cent of consumers experienced improvements
in their ability to compare funds, rank funds and identify cheaper funds.
Langevoort, Lawmaker.
The FSCP has suggested that the FSA’s removal of its ‘Menu’ requirement (with respect to
standardized disclosure of firm commissions) was premature, partly as the FSA had not
considered the possibility of long-term improvements in investor understanding: FSCP,
Annual Report 2007–2008, pp. 37 and 43.
J. Cox and J. Payne, ‘Mutual Fund Expense Disclosures: A Behavioral Perspective’ (2005)
83 Washington University Law Quarterly 907, drawing on concepts developed by Russo (E.
Russo, ‘The Value of Unit Price Information’ (1977) 14 Journal of Marketing Research 193);
and, for a practical application, J. Kozup and J. Hogarth, ‘Financial Literacy, Public Policy
and Consumers’ Self Protection – More Questions, Fewer Answers’ (2008) 42 Journal of
Consumer Affairs 127.
Rachlinski, ‘Uncertain Psychological Case’. 87 Kozup and Hogarth, ‘Financial Literacy’.
Calls for disclosure to be ‘road-tested’ on retail investors are becoming increasingly frequent. E.g. Australia–New Zealand Shadow Financial Regulatory Committee, Responding
to Failures in Retail Investment Markets, Statement No. 3, 25 September 2007.
E.g. Better Regulation Executive (BERR) and National Consumer Council (NCC), Too
Much Information Can Harm: A Final Report by the BERR and the NCC on Maximising the
Positive Impact of Regulated Information for Consumers and Markets (2007) and BERR and
the NCC, Warning! Regulated Information: A Guide for Policy-Makers (2008).
302
disclosure
regulatory regime already grapples with how regulation might support
the achievement of optimum outcomes through the suitability regime.90
So too must the disclosure regime. Optimum decisions against which
disclosure could be tested might include the investor adequately addressing diversification, market risks and the impact of costs and aligning
the investment choice with her risk appetite and investment needs. An
outcomes-based approach to disclosure is demanding.91 It requires much
more than fiddling with formats and content.92 It calls for much deeper
drilling into investor needs and risks and into how investors and disclosure
interact. But it is necessary if disclosure is to be more than cosmetic.
Efforts are also needed to integrate EC disclosure policy with the emerging financial literacy strategy;93 the strategy could, for example, highlight
the importance of investors using regulated disclosures.94 Given incentive
misalignment, it falls to public authorities to deliver key risk messages
on the investment process more generally, whether through an investor
education strategy or by requiring educational disclosures in regulated disclosures. There is also some evidence from the CIS context that financial
capability strategies can improve decision-making, and thus the effectiveness of disclosure.95 But the EC’s investor education strategy is embryonic
and, thus far, more concerned with overall financial literacy and basic
money skills and there is no evidence of any enthusiasm for education
messages to be incorporated into regulated disclosures.
Some recent developments, however, augur well for EC disclosure policy ‘in action’. The UCITS Directive (section II below) has experienced a
series of reforms which have culminated in the new KII model which – for
the first time in EC investor protection regulation – is being tested on retail
90
91
92
93
94
95
See further ch. 4.
A recent US study on the proposed SEC mutual fund summary prospectus has found no
evidence that it affected the quality of portfolio choice: J. Beshears, J. Choi, D. Laibson and
B. Madrian, How Does Simplified Disclosure Affect Individual Mutual Fund Choices? (2008),
available via www.aeaweb.org.
‘[T]he key lies not in the constant tweaking of documents in the hope that this time they will
work to encourage rational and informed decision-making, but requires a return to “first
principles” and a reassessment of the aims of, and potential for, information disclosure’:
Gray and Hamilton, Implementing Financial Regulation, p. 213.
The FSA is now relating disclosure reform to its financial capability initiatives and to
‘helping consumers to recognize the importance of these documents’: FSA, Reforming
Conduct of Business Regulation (Consultation Paper No. 06/19, 2006), p. 124.
J. Kozup, E. Howlett and M. Pagano, ‘The Effects of Summary Information on Consumer
Perceptions of Mutual Fund Characteristics’ (2008) 42 Journal of Consumer Affairs 37.
The 2008 CRA Report suggested that the increase in reliance on charges disclosure in
investor CIS selection from 14 per cent in the 2002 Sandler Report to 28 per cent in its
research might be related to FSA efforts to improve financial capability (p. 19).
disclosure and ec investor protection
303
investors. While MiFID’s more general disclosure regime for investment
services and investment products is problematic in many respects, it contains some innovations and its principles-based model carries the promise,
at least, of supporting market innovation; the over-arching requirement
that disclosure be fair, clear and not misleading may see disclosure become
less a function of tick-the-box compliance and more a function of careful consideration of what is likely to meet investor needs, although this
demands strenuous supervisory efforts.
More generally, heartening evidence is emerging of an appreciation
of the limits of retail market disclosure, particularly in MiFID’s support
of supply-side fiduciary principles, and of the need to test disclosure
formats.96 Institutionally, FIN-USE has emerged as a vocal sceptic of
disclosure;97 it should provide the constant irritant required to drive
improvements. The 2007 Green Paper on Retail Financial Services revealed
some scepticism concerning disclosure, and highlighted concerns that
investment product disclosure, in particular, is too complex, inadequate,
difficult to understand and does not support informed choice,98 while the
Commission’s commitment to reviewing the pre-contractual disclosure
regime, given the risk that the ‘current variety and accumulation’ of
information could confuse both the industry and consumers,99 generated
the important 2008 Optem Report. Even in the troublesome issuer
disclosure field, where disclosure reform lags some considerable distance
behind reform in the investment product sphere (despite some evidence
of heavier reliance by direct investors on disclosure100 ), there are some
signs of an emerging concern to improve prospectus disclosure, if not
ongoing disclosure.101
The lesson from the mass of evidence now emerging on the effectiveness of disclosure is a cautionary one. Disclosure is arguably the most
cumbersome of the three main levers (design, disclosure and distribution)
96
97
98
99
100
101
The US SEC, by contrast, has been described as having a ‘hard cultural shell’ of resistance to
evidence which might suggest that its reliance on disclosure is not warranted: Langevoort,
Lawmaker, p. 20.
E.g. FIN-USE, Opinion on the Commission Green Paper on the Enhancement of the EU
Framework for Investment Funds (2005); and FIN-USE, Financial Services, Consumers
and Small Businesses: A User Perspective on the Report of the Banking, Asset Management,
Securities and Insurance of the Post FSAP Stocktaking Groups (2004).
European Commission, Green Paper on Retail Financial Services, p. 16.
European Commission, White Paper on Financial Services, pp. 6–7.
Deaves Report, p. 247. By contrast, however, the TNS-Sofres Report found that
49 per cent of investors described as active shareholders used disclosures from listed
companies, while 75 per cent of collective investment scheme investors used disclosures
from financial institutions: TNS-Sofres Report, pp. 9–10.
See further ch. 6.
304
disclosure
at the regulator’s command, given its dependence on investor capability.
Real improvements in investor outcomes are, in the short to medium term
at least, most likely to be a function of the advice/distribution process, the
efficiency of which is related to the product design process. But disclosure
has a role to play in the advice/distribution process. It may be that alternative targets for disclosure should be factored into the design of disclosure.
Given the evidence of heavy dependence on advisers, of some form or
other, across the Community, and persistent concerns as to the quality
of advice and, increasingly, concern that advisers do not understand the
products which they distribute, it may be that product disclosures are
better regarded as targeted towards the adviser, rather than the ultimate
investor.102
II. Investment product disclosure (1): the UCITS regime
1. Designing CIS disclosure: the challenge
a) Disclosure difficulties
Disclosure is strongly associated with investor protection in the CIS
sphere.103 By improving decision-making it can, in theory, enhance product quality and lead to downward pressure on CIS costs.104 But designing effective disclosure for CISs is complex given the weight of evidence
demonstrating that investors do not read CIS disclosures, find them
complex and favour short-form disclosures.105 The difficulties are compounded by the dual role of pre-contractual CIS disclosures as investor
102
103
104
105
As has been suggested by the FSA’s FSCP (FSCP, Annual Report 2007–2008, p. 43). CESR
has similarly acknowledged that the KII model should allow advisers to compare products
(CESR 2008 KII Advice, p. 24), while a leading retail market stakeholder has suggested
that the effectiveness of the KII be tested on advisers: Danish Shareholders’ Association,
Response to CESR’s Key Investor Information Consultation (2007), p. 1.
E.g. Zingales’ prescription for post-credit-crunch securities regulation reform includes
CIS disclosure reforms (L. Zingales, The Future of Securities Regulation (2009), ssrn
abstractid=1319648), while the Dutch AFM has noted that ‘consumer responsibility in an
increasingly dynamic financial arena starts with proper provision of information’: AFM,
Risk Indicator, p. 5.
Cox and Payne, ‘Mutual Fund Expense’, 930.
One US industry study (Investment Company Institute, Understanding Investor Preferences
for Mutual Fund Disclosure (2006)) found that only one-third of investors surveyed read
fund prospectuses, 60 per cent found them difficult to read and 90 per cent preferred
short-form disclosure: pp. 4–5 and 8–9. The similar and extensive UK evidence includes
FSA, Consumer Research No. 5, which reported that investors were ‘simply not reading’
product disclosures (at pp. 22–3) and FSA, Key Facts Quick Guide: Research Findings
(Consumer Research Paper No. 41, 2005).
product disclosure (1): the ucits regime
305
information and as marketing devices and the risk that investors dismiss
disclosures as marketing efforts.
Complex CIS prospectuses, it is now clear, serve little purpose for the
retail investor who prefers concise summaries. Past performance information, a widely used marketing tool for CISs (and notwithstanding
firms’ awareness that past performance is not a good indicator of future
performance106 ), is particularly problematic. While it is emphasized by
retail investors,107 extensive research shows that it is often poorly understood and vulnerable to over-reaction.108 Strong past performance has
been repeatedly shown to lead to abnormally high CIS inflows.109 Past
performance disclosure has also been associated with often prejudicial
procyclical investment patterns.110 Decision-making risks have led to calls
for a prohibition in some quarters, given that the risks might be accentuated by its inclusion in regulated disclosures.111 The traditional pairing
of past performance disclosure requirements with risk warnings as to its
limitations certainly appears disingenuous.112 The FSA appears keen to
downplay its importance,113 although it persists in the EC regime; the
106
107
108
109
110
111
112
113
P. Jain and J. Wu, ‘Truth in Mutual Fund Advertising: Evidence on Future Performance
and Fund Flows’ (2000) 55 Journal of Finance 937, 957.
Forty-eight per cent of investors surveyed in the BME study identified past performance
information as fairly or very important in making an investment decision: BME Report,
p. 148.
A series of FSA studies show that past performance is not a reliable indicator of future CIS
performance, that it is not exploited effectively by investors, who can react emotionally
to it, and that interpretation difficulties are considerable: FSA, Report of the Task Force
on Past Performance Information (2001); FSA, Past Imperfect: The Performance of UK
Equity Managed Funds (Occasional Paper No. 9, 2000); and FSA, Standardization of Past
Performance Information (Consumer Research No. 21, 2003), p. 7. The FSA has also
highlighted the particular risks it poses in the promotion of complex products: FSA,
Financial Risk Outlook 2006, p. 87.
Deaves Report, pp. 241, 258–9.
J. Delmas-Marsalet, Report on the Marketing of Financial Products for the French Government (2005) (‘Delmas Report’), p. 9.
A minority of the FSA’s 2001 taskforce recommended a prohibition given that past performance does not predict future performance, is difficult to present without inviting
over-reliance and risks the perception of regulatory endorsement: FSA, Report of the
Taskforce, p. 15.
Hu has criticized the SEC’s past performance disclosures and risk warnings citing an
experiment in which students told ‘not to think of a white bear’ found it very difficult
to comply: H. Hu, ‘The New Portfolio Society, SEC Mutual Fund Disclosure, and the
Public Corporation Model’ (2005) 60 Business Lawyer 1303, 1314–16. Similarly, Palmiter
and Taha argue that the tendency for investors to be ‘mesmerized’ by past performance
disclosure is unlikely to be addressed by a requirement for this disclosure: Palmiter and A.
Taha, Mutual Fund Investors, pp. 27–8.
E.g. Consultation Paper No. 170, p. 9.
306
disclosure
recent KII reforms have not grasped the abolition nettle. Projections,
another feature of CIS disclosure, raise similar difficulties.
Retail investors also face particular difficulties in comparing risk profiles and risk-return models. Standardized or synthetic risk indicators can
support investor understanding and comparability114 and have emerged
as a feature of the recent market115 and regulatory116 attempts to enhance
disclosure. But they raise complex issues for regulatory design, not least as
they must engage with poor retail investor understanding of risk and must
balance risk proxies with investor perceptions of risk. There is also some
doubt as to whether they can drive informed decision-making,117 particularly as they may over-simplify the investment decision.118 Similarly,
labelling devices, designed to signal the type of investors likely to invest in
the fund, carry the risk of blurring the distinction between product development and the suitability obligations imposed on the distribution layer.
Costs disclosure is particularly sensitive given the range of costs which
can be incurred directly and indirectly by the investor119 and as costs
are a key determinant of, and can impact heavily and detrimentally on,
returns.120 Costs are also the most important way in which managers can
extract value to the detriment of investors, given the conflict-of-interest
114
115
116
117
118
119
120
The retail sector tends to support risk indicators. The Optem Report found poor investor
engagement with terms such as ‘medium-low’ risk but support for numerical indicators (p.
109). Nationally, the TNS-Sofres Report noted that investors were receptive to composite
risk indicators (p. 41), while the Dutch AFM has reported that consumers attach great
importance to visual risk presentations, with 63 per cent preferring graphic presentations:
AFM, Risk Indicator, p. 6. Similarly, the FSA’s FSCP undertook research which showed
retail investor appetite for risk indicators, although some concern as to whether indicators
were trustworthy (FSCP, Annual Report 2007–2008, p. 41).
CESR has pointed to the efforts made by the asset management industry to develop risk
indicators on a voluntary basis: CESR, Advice to the European Commission on the Form
and Content of Key Information Disclosures for UCITS (CESR/08-087, 2008) (‘CESR KII
Advice 2008’), p. 33.
The AFM’s Financial Information Leaflet for investment products requires that a graphic
risk indicator of volatility, in the engaging form of a person carrying a burden, is provided
(it is designed to reflect the average payout in the event of unfavourable contingencies
after particular time periods), although only 50 per cent of risk indicators were found to
be in order following a 2006 review: AFM, Annual Report 2006, p. 52.
Palmiter and Taha, Mutual Fund Investors, pp. 35–6.
IMA, Response to CESR KII Consultation, 18 December 2007, pp. 2 and 15.
Including: direct exit and entry costs; indirect costs charged to the scheme, including
marketing and distribution costs, management and administration costs, and portfolio
transaction costs (or the brokerage costs of executing fund transactions); performance
fees; and fee-sharing arrangements and soft commissions.
Oxera, Towards Evaluating Consumer Outcomes in the Retail Investment Products Markets:
A Methodology: Prepared for the Financial Services Authority (2008), pp. i–ii.
product disclosure (1): the ucits regime
307
rules and asset protection rules, concerning managers and depositaries,
which typically apply (including under the UCITS regime121 ) to potentially
prejudicial transactions between managers and the CIS.122 Distributionlinked conflict-of-interest risks also arise through the payment of fees
and commissions to distribution networks and advisers. The difficulties
are exacerbated by the well-documented difficulties faced by investors in
extracting and understanding the extent, nature and implications of different costs from prospectus disclosure.123 There is some evidence that
investors may, over time, become more aware of the impact of front-end
fees and so impose competitive discipline on high-cost schemes.124 But
investors appear to have considerable difficulties in assessing the impact of
more opaque operating expenses and in discounting the effect of marketing costs.125 The complexities of effective cost disclosure are only increased
by the growing tendency for investment product sales and advice to be
provided through wraps and platforms, which can further complicate
cost disclosure.126 The difficulties are all the greater as cost disclosure
in isolation is of limited use without comparability.127 The design challenges are therefore formidable. The UK regime, for example, relies on two
devices, Reduction in Yield disclosure and the Effect of Charges Table; but,
although FSA research suggests that these devices can improve investor
understanding, the margin for improvement is considerable.128
121
122
123
124
125
126
127
128
See further ch. 3.
J. Coates and R. Hubbard, ‘Competition in the Mutual Fund Industry: Evidence and
Implications for Policy’ (2007) 33 Journal of Corporation Law 151, 161.
The 2008 CRA Report, for example, found that, while retail investors had some understanding of the importance of charges, there was a weak correlation between fund inflows
and charges and that only 28 per cent of investors highlighted charges as a main factor in
the product decision: pp. 3 and 17–19. In the Australian context, ASIC (ASIC, Report 23,
A Model for Fee Disclosure in Product Disclosure Statements for Investment Products (2003)
(which followed the Ramsay Report on fee disclosure (I. Ramsay, Disclosure of Fees and
Charges in Managed Funds (2002)) has highlighted that fee disclosure is the ‘most difficult
to understand’ for retail investors (p. 10). Poor investor ability to assess costs has also
been the subject of an extensive US scholarship. E.g. J. Freeman and S. Brown, ‘Mutual
Fund Advisory Fees: The Costs of Conflicts of Interests’ (2001) 26 Journal of Corporation
Law 609; and J. Bogle, ‘Reformulating the Mutual Fund Industry: The Alpha and Omega’
(2004) 45 Boston College Law Review 391.
Coates and Hubbard, ‘Competition’.
B. Barber, T. Odean and L. Zheng, ‘Out of Sight, Out of Mind: The Effects of Expenses on
Mutual Fund Flows’ (2005) 78 Journal of Business 2095.
FSA, Platforms: The Role of Wraps and Fund Supermarkets (Discussion Paper No. 07/2,
2007), pp. 45–7.
Payne and Cox, ‘Mutual Fund Expense’, 935–6.
2008 CRA Report, pp. 37–43.
308
disclosure
b) Reform efforts
The disclosure challenge is therefore considerable. But its careful management lies at the core of efforts to support an effective demand side,
although resolution thus far appears to have eluded regulators, despite
strenuous international reform efforts. A convincing argument can be
made that CIS disclosure, which traditionally focuses on the scheme’s
investment management mandate and objectives, does not capture retail
investor risks, as returns are largely dependent on the scheme’s choice
of asset class, and regulated disclosures should accordingly focus on the
relative risks and performance of different asset classes.129 The current
international reform movement is, however, less ambitious and focuses
on the simplification of detailed prospectus disclosures.130 Following concerns as to the inappropriateness of fund disclosure in delivering key
investor protection messages,131 the US SEC, for example, reformed its
disclosure regime in 1998 to allow funds to prepare a ‘profile’ containing
key disclosures.132 The voluntary profile was not, however, widely used by
retail market funds given the liability risks from any omission of material
information, and in 2007 the SEC announced significant reforms, requiring product providers to include standardized, simplified disclosures in
prospectuses.133 These efforts have been followed by reforms designed to
facilitate the comparability of required disclosures across funds through
an interactive data model.134 The simplification of product disclosure has
also been a feature of the Australian regime which has seen short-form,
principles-based disclosure reforms.135
These efforts have been replicated in the Community. The FSA’s Key
Features Document (KFD) for ‘packaged products’, which includes a ‘key
facts’ logo to raise investor awareness of the importance of regulated
disclosures and to deal with the risk of confusion between marketing
documents and regulated disclosures, supports disclosure across a range
129
130
131
132
133
134
135
Hu, ‘The New Portfolio Society’.
Well reflected in IOSCO, Investor Disclosure and Informed Decision-Making: Use of Simplified Prospectuses by Collective Investment Schemes (IOSCO, 2002), p. 2.
R. Robertson, ‘In Search of the Perfect Mutual Fund Prospectus’ (1999) 54 Business Lawyer
461, 475.
Release No. 33-7513 (1998). The SEC also amended its disclosure rules for full mutual
fund prospectuses as it was concerned that prospectuses are often ‘legalistic disclosure
documents that are difficult to read, hard to understand and prepared with litigation in
mind’: SEC Release No. 33-7512 (1998).
SEC, Press Release 15 November 2007, available via www.sec.gov/news/press/2007/.
SEC, Press Release 2008-94, available via www.sec.gov/news/press/2008/.
Australian Treasury, Refinements to Financial Services Regulation: Proposals Paper (2005).
product disclosure (1): the ucits regime
309
of packaged investment products (including UCITS, non-UCITS CISs,
investment trusts with a regular savings component and unit-linked insurance products). The KFD is delivered at the point of sale, along with disclosure on product charges and, for life insurance products, projections of the
possible return based on different growth assumptions (the Key Features
Illustration). From the outset, it has undergone a series of reviews which
all point to the complexities of effective disclosure design.136 A 2000 review
found that consumers did not have greater understanding when provided
with the KFD, that they sought other disclosures, were confused by the
terms used and unable to compare products, had poor understanding of
charges, often did not read the documents and that the brand and reputation of the product provider were more influential on the investment
decision than disclosure;137 investors also preferred to rely on advisers
or choose investments on the basis of past performance.138 In 2005, the
FSA considered replacing the KFD with a shorter ‘Quick Guide’139 following market testing which underlined the importance investors attach
to clear and short documents.140 But this reform was abandoned in 2006
following extensive research141 which suggested that, while investors liked
the Quick Guide, its benefits as compared to the KFD would be limited and implementation costs considerable.142 The FSA has, however,
streamlined the KFD, partly in response to MiFID’s disclosure requirements, to make it shorter, more focused and better laid out and to allow
firms flexibility in tailoring KFDs to their specific products and target
audiences.143 But, despite the FSA’s long experience with, and focus on,
136
137
138
139
140
141
142
143
E.g. FSA, Consumer Research No. 5; FSA, Consultation Paper No. 170; and FSA, Projections
Review – The Case for Change (Discussion Paper No. 04/1, 2004).
FSA, Consumer Research No. 5.
Ibid., p. 25. Similar results concerning heavy adviser reliance were reported later in FSA,
Key Facts Quick Guide: Research Findings (Consumer Research No. 41, 2005), pp. 8–9.
FSA, Investment Product Disclosure: Proposals for a Quick Guide at the Point of Sale (Consultation Paper No. 05/12, 2005); and FSA, Consumer Research No. 41. In addition to
format and presentation reforms, the Quick Guide was designed to adopt a ‘less is more’
approach.
The KFD was found to be failing to lead investors to read the document and to support
informed decision-making, given a perception that it was ‘boring’ and failed to ‘stand out’
as an important source of information.
Investment Disclosure Research (Consumer Research No. 55, 2006); and Point of Sale
Investment Product Disclosure: Feedback Statement (Feedback Statement No. 06/5,
2006).
FSA, Consultation Paper No. 6/19, pp. 119–32.
A. Sykes (FSA), Speech, KFD Seminar, 6 May 2008, available via www.fsa.gov.uk/Pages/
Library/Communications/Speeches/index.shtml.
310
disclosure
the KFD, it remains problematic.144 A 2007 assessment revealed that only
15 per cent of KFDs met the required standard, over one-third were
poor or ineffective,145 and that, while the remaining documents met formal regulatory requirements, only well-informed and engaged investors
would have been able to understand the important features of the product in question.146 While the FSA has called for significant and sustained
improvements in KFD standards,147 the scale of the supervisory effort
required, the range of levers which the FSA deems necessary to drive
stronger compliance (including enforcement and industry measures148 )
and the persistence of industry failures149 does not augur well for
MiFID’s principles-based investment product disclosure regime, discussed
below.
The Dutch AFM has also focused on investment product disclosure.
Since 2002, it has required a ‘Financial Information Leaflet’ for a range
of investment products.150 Reflecting the FSA’s experience, the leaflet has
been reformed,151 but nevertheless it is generally regarded as a successful
model.152 CIS disclosure has also been a concern of empirical study and
reform in France.153
144
145
146
147
148
149
150
151
152
153
E.g. FSA, Consumer Purchasing and Outcomes Survey (Consumer Research No. 76, 2009).
FSA, Treating Customers Fairly – Measuring Outcomes (2007), p. 15.
FSA, Good and Poor Practices.
FSA, Major Retail Thematic Work Plan for 2008–2009, p. 5.
The drive to improve the KFD is based on engagement with trade associations, the inclusion
of KFD quality in the FSA’s Major Retail Thematic Work Plan and specific supervisory and
enforcement strategies. The 2008–2009 Major Retail Thematic Work Plan, for example,
saw the FSA commit to addressing poor KFD compliance with individual firms, working
with trade bodies to improve KFD production and reviewing a subsequent sample of
KFDs to assess compliance: ibid.
Poor compliance occurs across small and large firms: FSA, Good and Poor Practices,
p. 7.
Enhancing product transparency has been a key priority of the AFM: AFM, Policy and
Priorities for the 2007–2009 Period (2007), p. 7.
A 2004 assessment concluded that its effectiveness could be improved if it contained less
information, the language was simpler and the presentation more attractive: European
Commission, Simplified Prospectus Workshops 15 May 2006 and 11 July 2006: Issues Paper
(2006) (‘Prospectus Workshops Issues Paper’), p. 20.
More than 70 per cent of consumers regard the Leaflet as assisting their understanding
of investment products: AFM, Development of a New Obligatory Financial Leaflet (2006),
presentation attached to European Commission, Simplified Prospectus Workshop 11 July
2006.
In addition to the TNS-Sofres Report, 2006 also saw the French AMF, in collaboration with
the industry, test a standardized format which highlighted key features on one side and
set out regulatory information on the other: Delmas Report, p. 26.
product disclosure (1): the ucits regime
311
CIS disclosure reform also requires consideration of the degree to which
intervention is appropriate. Detailed prescription in support of comparability and standardization is likely to lead to obsolescence risk, stunt
industry innovation and impose regulatory perceptions as to investor
needs which may be ill-considered. Innovative industry solutions can be
developed: EFAMA has developed a CIS classification system designed in
part to address the severe limitations on effective investor choice across
the universe of UCITS and non-UCITS funds.154 It has also developed a
model simplified prospectus.155 But industry incentives to produce effective disclosure can be weak given the limited discipline exerted by retail
investors and the evidence of poor industry compliance unless the regulatory incentives are strong. Quality may also be a significant casualty
if standards are not sufficiently rigorous;156 the Dutch AFM’s experience
with self-regulatory codes of conduct for disclosure on structured securities has not been encouraging.157
The difficulties are all the greater in the EC/UCITS context. Harmonization carries a series of benefits aside from supply-side cost reduction,
including support of standardization, which seems to be favoured by EC
investors.158 But the relative inexperience of the EC as a retail market regulator stands in stark contrast to the intensive and yet often flawed efforts
made by regulators worldwide. Particularly acute difficulties arise concerning the target investor, given the wide variances in competence, risk
appetite and investment behaviour across the EC and the inevitable tendency of reforms to rely on troublesome models of the ‘average’ or ‘typical’
investor. But some conception of what information is, in practice, regarded
by ‘EC investors’ as important must be married to rule design if effective
154
155
156
157
158
EFAMA, The European Fund Classification (2008).
FEFSI, User Manual for its Model Simplified Prospectus. In the UK, the Association of
British Insurers’ Raising Standards Quality Mark Scheme has also been associated with a
simplification of disclosure standards.
In its Article 4 application to retain its KFD regime for non-UCITS products, the FSA
argued that ‘past experience in the UK market indicates that the standard and quality of
information provided to clients would be uneven and inconsistent without an obligation
to provide prescribed information in a relatively standard form’: Article 4 Application,
p. 20.
European Commission, Record of the Open Hearing on July 15 2008 on Retail Investment
Products (2008), pp. 16–17 (in which the AFM highlighted the difficulties it faced in
ensuring consistent and comparable information).
The Optem Report reported some investor enthusiasm for a ‘standardized sheet’ for
investment product disclosure as it would ‘facilitate comparisons’ and help investors
to ‘get to grips with the sector’ and ‘gain back some autonomy from banks, financial
institutions and other professionals’: Optem Report, p. 113.
312
disclosure
outcomes are to be achieved. Effective disclosure depends heavily on ‘processability’, on formats and on standardization; but these have not been
features of the EC retail market regime until very recently. Some degree of
flexibility is also required to support innovation and avoid cumbersome
‘one-size-fits-all’ models; the UCITS regime has prevented Member States
from making radical reforms, such as the abolition of past performance
disclosure requirements or with respect to format requirements.159 The
market integration imperative can also mask the nature of the reforms
required in practice. The troublesome UCITS simplified prospectus was
designed to support market integration and to be used as a ‘single marketing tool throughout the Community’160 in that the host Member State is
not permitted to impose any additional prospectus requirements or modifications, bar translation requirements (UCITS Directive, Article 28(3)).
But the document failed to support investor understanding, although it
was described as ‘a benchmark marketing tool, the culmination of the
Commission’s maximum harmonization approach in this matter’.161 The
prize is considerable, however, not least as effective disclosure ‘in action’
may reduce the tendency of investors to over-rely on potentially conflicted
intermediation channels.
2. The EC laboratory
a) The UCITS disclosure regime
The harmonized UCITS disclosure regime is of central importance to
the EC’s attempt to build an informed cohort of retail investors. It is
also a key indicator for whether the EC’s commitment to the demand
side is anchored to practical, operational innovations and disclosure ‘in
action’. The evolution of the disclosure regime from an arcane original
model, based on extensive disclosure and designed, in part, to support
cross-border marketing by the UCITS, to an evidence-based, investorfacing model, designed to support informed decision-making, marks a
sea-change in EC retail disclosure policy. It also illustrates the ability of the
159
160
161
The restrictions imposed by the UCITS simplified prospectus regime were highlighted by
the FSA in its attempts to remodel its KFD: for example, FSA, Consultation Paper No. 170,
p. 9.
European Commission Recommendation 2004/384/EC of 27 April 2004 on some contents
of the simplified prospectus, OJ 2004 L144/42 (‘Simplified Prospectus Recommendation’),
recital 1.
European Commission, Communication to the Parliament on the Common Position (SEC
(2001) 1004), para. 3.2.2.7.
product disclosure (1): the ucits regime
313
EC investor protection regime to incorporate practical disclosure reforms
and, through CESR, to capture national innovation in disclosure design.
It remains to be seen whether the new KII design, which forms part of the
UCITS IV reforms, will be effective, but the redesign process is a landmark
in the development of the EC investor protection regime.
b) Poor disclosure design
The UCITS Directive disclosure regime is characterized by its assumption
that disclosure can support investor understanding but also, until recently,
unsatisfactory attempts to deliver processability. It is unfair to criticize the
regime for its original (and current) requirement for detailed prospectus
disclosure and annual/half-yearly financial reports, which must be made
available to UCITS subscribers, and distributed cross-border where the
UCITS is marketed outside its home State (Articles 27(1), 32, 33 and 47),
which reflects in part the requirements of professional investors. Similarly,
the linkage between the UCITS III reforms and the introduction of related
disclosure requirements concerning the increased risk profile of UCITS
III products is not unreasonable in principle (Article 24a). But difficulties
arise concerning the treatment of UCITS disclosures which are expressly
targeted to the retail investor and the poorly executed attempts to support
investor understanding, particularly with respect to UCITS III products.162
The UCITS regime has struggled in reconciling its attachment to the
notion that retail investors can decode disclosures with the challenges
posed by achieving processability ‘in action’. The detailed prospectus
must, for example, contain the information necessary for the investor
to make an informed judgment of the investment proposed (Article 28),
and the current cumbersome translation regime, which requires translation of disclosures into host State languages (Article 47), carries the
implication that investors will read the disclosures. On the other hand,
prospectus and financial report disclosures are lengthy (Schedules A and
B) and prospectus disclosures can be distributed and fragmented across the
UCITS prospectus and constitutional documents (Article 28(2)). The simplified prospectus requirement, introduced with the UCITS III reforms,163
162
163
Concerns have been raised that UCITS III prospectus disclosure might be insufficient to
support retail investor understanding of the risks: PricewaterhouseCoopers, Investment
Funds in the EU: Comparative Analysis of the Use of Investment Powers, Investment Outcomes
and Related Risk Features in Both UCITS and Non-Harmonized Markets (2008) (‘2008 PwC
Investment Powers Report’), p. 67.
Directive 2001/107/EEC of 21 January 2002, OJ 2001 No. L41/20 (‘Management Company
and Prospectus Directive’).
314
disclosure
while an important staging post (along with its partner 2004 Recommendation on the content of the simplified prospectus), clung to the notion
that short-form disclosures, without more, could support better decisionmaking. The simplified prospectus was to constitute a ‘key element of
investor protection’,164 to deliver key information about the UCITS in a
clear, concise and easily understandable way165 and to allow the investor
to make an ‘informed judgment’ of the investment proposed and its risks
(Article 28(1)). Its partner Recommendation was designed in part to support comparability (recital 7). These ambitious aims were delivered largely
by means of a requirement that it provide a ‘clear and easily understandable’ explanation of the UCITS risk profile (Article 28(1)). It also introduced the elusive notion of the ‘average investor’ who should be able to
understand the prospectus easily (Article 28(3)) and required a discussion
of the profile of the ‘typical investor’ the UCITS is designed for. But the simplified prospectus was adopted without ex ante testing.166 It only shortened
and highlighted the still lengthy disclosures to be made to retail investors
(UCITS Directive, Schedule C). It did not address format and did not
address the particular decision-making difficulties, notably with respect
to past performance and costs, experienced by retail investors. Although,
for the first time in EC securities regulation, it addressed past performance, requiring that details of UCITS past performance be provided and
a warning that it is not an indicator of future performance (Schedule C),
it did not engage with presentation or format (although the Recommendation suggested bar-chart presentation (Recommendation 1.5.1)). The
Recommendation was equally traditional, containing, for example, a risk
disclosure regime of such detail167 as would represent a challenge to the
most diligent of retail investors, although it also recommended that risk
disclosures be relevant, material and based on risk impact and probability,
and prioritized (Recommendations 1.4.1 and 1.4.2.3). More innovative
attempts to support understanding included the suggestion that Member States develop a quantitative synthetic risk indicator to represent the
volatility of UCITS, and the important recommendation that Member
States adopt a Total Expense Ratio (TER) (Recommendation 2.2.1) which
164
165
166
167
Management Company and Prospectus Directive, recital 2.
Management Company and Prospectus Directive, recital 15.
FIN-USE, User Perspective, p. 25; and CESR KII Advice 2008, p. 11.
The Recommendation covers the specific and horizontal risks which should be covered
by a ‘brief and understandable’ explanation, including market, credit, settlement, liquidity, custody, concentration, performance, capital, guarantee, flexibility, inflation and
environmental (including taxation) risks.
product disclosure (1): the ucits regime
315
would indicate all costs borne by the investor in relation to the investment,
calculated with respect to the fund’s total operating costs (the TER does
not, however, include entry and exit costs or portfolio transaction costs or
address distribution costs directly168 ). The Recommendation was, however, constrained by its voluntary nature and variable implementation,
particularly with respect to the risk indicator which, in theory at least, had
some potential,169 did not reflect domestic presentation innovations and
did not engage with the standardization of formats.
The UCITS regime also struggles with ‘point-of-sale’ delivery of disclosure, often identified as key for informed decision-making.170 The
prospectus delivery requirement applies only to the UCITS investment
company or management company, and so to direct sales to investors. But
the range of channels through which UCITS can be sold include intermediated/advised sales through UCITS-affiliated actors, third-party channels, including open-architecture distribution networks and independent
financial advisers, and sales of wrapped products. The prospectus may
not, therefore, be delivered at the point of sale. Where the third-party distributor or adviser is a MiFID firm, MiFID disclosure requirements apply,
but MiFID imposes only high-level disclosure requirements and does not
require that investors be provided with a UCITS prospectus (although
its disclosure requirements may be satisfied by supplying investors with a
UCITS prospectus (MiFID Level 2 Directive, Article 34)). The quality of
advice also depends on MiFID distributors and advisers receiving effective
disclosure from UCITS product providers,171 which is not addressed by
the UCITS regime.
Dissatisfaction with the simplified prospectus soon emerged; in itself,
this groundswell is revealing, reflecting the emergence of a wider concern
168
169
170
171
It covers the total UCITS operating costs deducted from the UCITS’ assets and includes
management costs and performance fees, administration costs and audit fees: Recommendation, Annex I.
The indicator was adopted by only five States: CESR, Implementation of the European Commission’s Recommendations on UCITS: Report of the Review Conducted by CESR (CESR/05302b, 2005), p. 5.
FSA, Consultation Paper No. 170, p. 12; and Deaves Report, p. 305.
The FSA has warned that distributors can receive poor-quality information from product
providers: FSA, The Responsibilities of Providers and Distributors for the Fair Treatment of
Customers (Discussion Paper No. 06/4, 2006). Point-of-sale disclosures were the subject
of US reform proposals which would have required broker-dealers to provide investors
with a short-form document (addressing key risks and commission disclosure) which
acknowledged the need for close communication between product providers and brokerdealers: NASD Mutual Fund Taskforce, Report on Mutual Fund Distribution (2005).
316
disclosure
to support the retail sector and enhance processability. Industry dissatisfaction combined with concerns as to the inadequacies of the simplified
prospectus, particularly given its length and complexity,172 its inability
to represent costs effectively and the failure of the TER, its failure to
support standardization and the weaknesses of the detailed and complex
Recommendation.173 The difficulties were exacerbated by the constraints
the regime placed on regulators in developing innovative local disclosure documents. By 2006, the Commission’s dismal finding was that the
prospectus had ‘manifestly failed . . . [it was] too long . . . not understood
by its intended readers’ and had generated a ‘massive paper chase of limited
value to investors and a considerable overhead for the fund industry’.174
c) Reforming UCITS disclosure: the Key Investor
Information document
Unlike the previous incremental and untested approach, the redesign of
UCITS disclosure and the construction of the new Key Investor Information (KII) document, a two-page document which will replace the
simplified prospectus and harmonize format, content and presentation,
has been based on a vastly more nuanced appreciation of investor competence and vulnerability and on a much clearer vision of the role of
summary CIS disclosure.
The reform has been traditional in that it has eschewed soft law and
industry measures and is based on greater harmonization, rather than
on the supervisory convergence techniques which are now available at
level 3 but which were, reflecting unhappiness with the Recommendation,
rejected as insufficiently robust to support a new disclosure system.175
The EC’s regulatory role in developing retail market disclosure formats
now appears to enjoy relatively wide industry and investor support.176 The
172
173
174
175
The TNS-Sofres Report found that only one-quarter of investors read or skimmed the
simplified prospectus (p. 26) and that, while it was generaly popular with retail investors
and regarded as ‘reassuring’, it was not easy to understand (p. 41). FIN-USE warned that,
‘while a step in the right direction’, it contained far too much information: FIN-USE,
Opinion on the Investment Funds Green Paper, pp. 3 and 6.
Major concerns included: inconsistent implementation of the Recommendation leading
to increased complexity and poor comparability; overly long and complex simplified
prospectuses which varied in length from two to four pages (UK), to eight (France), to
eleven (Italy); and its non-binding nature: Commission, Feedback Statement to the Green
Paper on Enhancing the European Framework for Investment Funds (2006), p. 8; and May
2006 Prospectus Workshop, p. 6.
European Commission, Investment Funds White Paper, p. 10.
E.g. Prospectus Workshops Issues Paper, p. 10. 176 Ibid.
product disclosure (1): the ucits regime
317
risks of harmonization have, however, been mitigated by a considerably
more sophisticated approach to disclosure design. In particular, efforts
have been made, for the first time, to test the reforms; notwithstanding the
risks associated with the notion of the ‘average EC investor’,177 this marks
a sea-change in disclosure design.
Consultation with stakeholders has been extensive. The initial 2006
Commission prospectus workshops, in which a wide range of stakeholders participated, saw the policy debate engage, for the first time, with a
range of practical design issues (including how to differentiate the KII
from a marketing document, structure, cost disclosures, risk disclosure
and synthetic risk indicators and past performance) and, overall, adopted
a practical approach, addressing ‘What does the investor need to know?’
The subsequent Commission ‘Initial Orientations’ document set out a
framework for possible reforms and was followed by a detailed request
for advice to CESR.178 CESR’s extensive initial consultation included three
calls for evidence (one on the content of the prospectus, one on distribution and one targeted to the retail sector179 ) in April 2007, a subsequent
October 2007 consultation paper180 (including a summary retail market
version181 ) and concluded with its February 2008 advice.182 CESR’s advice
was followed by the UCITS IV Proposal, strenuous testing efforts,183 further CESR consultation184 and a mandate from the Commission to CESR
for level 2 KII rules.185
CESR has proved effective in dealing with the reform. The Commission
originally requested of CESR a ‘root and branch rethink’ of how UCITS
disclosure should be structured and delivered, including how key risk disclosures, cost disclosures and past performance information (the Commission challenged CESR to consider whether past performance information should be prohibited) should be presented, and how distribution
risks could be addressed. In its response, CESR has emerged as central
177
178
179
181
183
184
185
The Commission’s initial approach was to direct the disclosures towards the ‘man in
the street’: European Commission, Exposure Draft, Initial Orientations for Discussion on
Possible Adjustments to the UCITS Directive: Simplified Prospectus (2006), p. 5.
Attached to CESR/07-241.
CESR/07-241; CESR/07-214; and CESR/07-205. 180 CESR/07-669.
CESR/07-753. 182 CESR KII Advice 2008.
The initial test results, and the testing process, are outlined in European Commission,
Workshop on KII 20 October 2008 and, in outline, in CESR, Consultation Paper on Technical
Issues Related to KII Disclosures for UCITS (CESR/09-047, 2009).
CESR/09-047.
European Commission, Provisional Request to CESR for Technical Advice on Possible Implementing Measures Concerning the Future UCITS Directive (2009).
318
disclosure
to retail market reforms and as able to corral a range of Member State
expertise, research and experience to inform the new regime. CESR’s 2008
model, reflected in the new UCITS IV KII regime discussed in this section below, was based on a single, one-sheet document model186 (the
Key Information Document (KID), now the KII), the contents of which
would follow a standardized order, and which would be subject to plain
language requirements.187 CESR based its advice on a clear articulation of
the purpose of the KII; it was, reflecting the empowerment model, ‘fundamentally a tool for helping retail consumers to reach informed investment
decisions’. CESR warned that it should not be encumbered with information serving only legal or regulatory requirements, or regarded as a
marketing or investor education document.188 A clear appreciation of the
importance of ‘processability’ is clear from its concern that testing not
simply address the relative popularity of different formats, but also, and
much more ambitiously, whether they would be used and understood by
investors.189 What is significant about this approach, other than the welcome focus on an informed decision-making outcome, is the breaking of
the link between Community action and market integration. The disclosure regime had hitherto been, in part, a function of the need to ease the
cross-border UCITS notification process. The KII, however, is entirely a
function of investor protection, although increased ease of comparability,
if it follows, may of course support stronger cross-border investment.
CESR also emerges as convinced of (and prepared to grapple with the
difficulties of) testing disclosure reforms on a pan-EC basis. Its past performance discussion, for example, considered the evidence on investor
misunderstanding190 and its advice more generally was placed in the context of international and Member State research on investor difficulties in
interpreting CIS disclosures.191 Although CESR’s pivotal 2008 KII advice
might be vulnerable to a fundamental weakness in that it is based on
domestic research which reflects national market characteristics, persistent themes concerning investor understanding reappear across national
studies. The 2007 BME Report suggests that common assumptions can
be made as to the generally limited knowledge base of investors across
the EC,192 while the 2008 Optem Report also supports the assumption
186
187
190
It rejected earlier building-block models on the grounds that investors were likely
to be confused and that useful comparisons would be impossible: CESR KII Advice 2008,
p. 7.
Ibid., pp. 18–23. 188 Ibid., pp. 6 and 18. 189 Ibid., p. 57.
Ibid., p. 41. 191 Ibid., p. 12. 192 See further ch. 2.
product disclosure (1): the ucits regime
319
that, while disclosure requirements are likely to differ depending on the
sophistication of the investor, certain requirements are requested by all
investors, and by certain categories of investor, regardless of Member
State.193 CESR also recommended that its proposals be tested. Testing is
in principle problematic given the lack of homogeneity in the EC retail
market, although troublesome references to the ‘average retail investor’
are scattered across the KII policy trail. But, while the difficulties are
considerable,194 they should not lead to an abdication of attempts to
design an evidence-based disclosure regime.
Although CESR proved willing to jettison previously required disclosure where they had proved ineffective,195 some (generally justified) conservatism is evident. With respect to risk indicators, for example, which
were supported by the retail constituency196 (support from other stakeholders was mixed), CESR pointed to the complexities and the risks where
indicators did not adequately capture all key risks and called for tests on
whether an indicator could improve investors’ perceptions of risk and
reward.197 A similar theme emerges from its past performance advice.
CESR’s advice focused on how this data could be safely presented and
suggested that mandatory performance benchmarks, against which past
performance data might be assessed, be tested.198 In an example of the
emerging voice of the retail sector, this controversial requirement was suggested by the retail sector, although it was rejected by leading industry
trade associations.199 CESR eschewed the more radical option of prohibiting past performance information (always unlikely given the industry
furore likely to have followed) on the pragmatic grounds that investors
were likely to source this information from other, perhaps more unreliable,
sources.200
193
194
195
196
197
199
200
Optem Report, pp. 89–92.
The subsequent Testing Workshop grappled with the difficulties of extrapolating findings
in the sample Member State to others.
It recommended, for example, that the portfolio turnover rate, recommended by the 2004
Recommendation, be removed as the average investor was not well equipped to interpret
it: CESR KII Advice 2008, p. 51.
Including FIN-USE, the AMF’s consultative panel and the Spanish CNMV’s consultative
panel; although the Danish Shareholders’ Association argued against the adoption of an
indicator.
CESR KII Advice 2008, p. 33. 198 Ibid., pp. 43–4.
Support came from FIN-USE and the Danish Shareholders’ Association, which, from the
outset, have been the main retail participants in CESR consultations, while the Investment
Management Association and EFAMA were opposed.
CESR KII Advice 2008, p. 42.
320
disclosure
The groundbreaking testing process201 has been extensive and, in itself,
holds some promise in that the data produced202 has significant potential
for illuminating how investment decisions are made, how disclosure is
processed in different markets and whether harmonization is, in practice,
desirable or practical.
CESR’s subsequent March 2009 consultation, which reflected initial
test results,203 addressed risk and reward, past performance and the design
of charges in groundbreaking detail; it also suggests a sea-change in the
sophistication of disclosure design. On the risk indicator, for example,
CESR suggested either an ‘enhanced narrative approach’ or a synthetic
risk and reward indicator, based on volatility,204 with mock-ups of the
different models to be tested by the Commission.
The UCITS IV proposal sets out the level 1 regime for the KII (Article
78) and the related delegation for the detailed level 2 format and content
rules (which will be based on CESR’s advice). It replaces the simplified
prospectus requirement with a new obligation that each investment company or management company draw up a ‘short document’ containing
key information for investors (the KII) about the essential characteristics
of the UCITS which, in a familiar formula, allows investors to be reasonably able to understand the nature and risks of the investment product
being offered to them and to take investment decisions on an informed
201
202
203
204
In addition to the Commission-led testing process, CESR set up three working groups and
consulted with industry representatives (particularly on risk indicator design).
Initial studies were based on samples of 500 respondents in the Member States covered
(which were limited to States with active UCITS markets and excluded France, the UK
and the Netherlands, given the degree of research already available on investors in those
markets).
Including investor preference for visual risk indicators, more confident comparisons and
risk assessment with an indicator but no prejudice to understanding, and a preference
for charges disclosure in table rather than text form, although difficulties persisted in
understanding the effect of charges.
The risk indicator is likely to: capture the volatility of the scheme’s weekly returns over a
three- to five-year period (or relevant proxies), given that volatility is an objective indicator,
capable of capturing other risks, including liquidity risk, easy to grasp, comprehensive
across UCITS, and easy to implement and verify (although CESR also acknowledged the
risks in terms of costs and investor confusion); be based on a 1 (low) to 7 (high) scale
(although lower-rated CISs would carry a warning that they are not risk-free); reflect three
general types of CIS (market (risk based on exposure to underlying market segments),
strategy (risks arising from active asset allocation) and structured (risks arising from
additional structuring of the risk)); and use modifiers, such as exclamation marks for
unlikely risk events, and risk warnings as to its limitations. Structured funds, for example,
could have an exclamation mark indicating, for example, rapid changes in risk profile:
CESR/09-047, pp. 7–26.
product disclosure (1): the ucits regime
321
basis (Article 78(1) and (2)). The KII must be written in a brief manner
and drawn up in a common format which, in a recurrence of a persistent
theme, allows for comparability, and the document must be presented in
a way likely to be understood by retail investors (Article 73(4) and (5)).
The new regime borrows from MiFID’s principles-based approach and
provides some protection against ‘tick-the-box’ compliance in that the
disclosure must be ‘fair, clear and not misleading’ (Article 79(1)). The
extensive level 2 delegation provides for ‘detailed and exhaustive’ rules on
the format and content of the KII as well as for tailored rules for a range of
different schemes.205 The new regime also addresses distribution risks ‘in
action’ through a direct/indirect sales model (Article 80) which requires
the UCITS product provider, where it sells the UCITS directly or through
a tied agent, to deliver the KII to the investor, either directly or through its
tied agent, in good time before the investor’s proposed subscription. For
indirect sales (such as those by investment advisers), and in a significant
innovation, the product provider must deliver the KII to intermediaries
who sell and advise investors on potential UCITS investments or, importantly, products (such as wrapped products) which offer exposure to such
UCITS.
The new document will be available for use without host State alterations or additions in all Member States where the UCITS is notified (under
the revamped UCITS passport/notification system206 ) to market its units
(Article 78(6)). It must, however, as befits a retail document, be translated into the official language or one of the official languages of the host
Member States or into a language approved by the competent authority
(Article 94). The original UCITS Directive translation regime is also
aligned with the issuer prospectus regime in that where the other UCITS
disclosures (including the scheme rules and full prospectus) are translated
(at the option of the product provider) the language is at the choice of
the provider.207 Although it reflects commercial pressures and costs and a
concern to streamline the notification process, this translation model will
place more stress on the KII and, as with the issuer prospectus regime,
205
206
207
Including UCITS with different investment compartments, UCITS with different share
classes, fund-of-funds UCITS, master–feeder UCITS, and structured, capital-protected
and similar UCITS: Art. 78(7).
The UCITS IV reforms include a new notification system designed to make cross-border
marketing more straightforward: Art. 93.
Other disclosures must be translated into the official language or one of the official
languages of the UCITS host Member States, into a language approved by the competent
authority of the UCITS host Member State, or into a language customary in the sphere of
international finance, in each case at the choice of the UCITS (Art. 94).
322
disclosure
compound the difficulties faced by retail investors in suing on the basis
of faulty UCITS disclosure. The Commission justified the dilution of the
translation obligation by suggesting that, in practice, retail investors did
not rely on these documents given their complexity;208 but the risk to the
retail sector remains.
The KII is a landmark in the development of EC retail market policy, both in terms of substantive reform and the process through which
it is emerging. With a blank sheet of paper and in the absence of pathdependencies, more radical solutions could have been canvassed. The
persistence of past performance disclosure remains problematic, particularly given the procyclicality risks exposed by the ‘credit crunch’ and dotcom eras. Comparability remains a policy distraction. The KII sits uneasily
with the evidence that investors have poor understanding of different asset
classes and of diversification; some room might have been made to mandate the inclusion of signposts to standardized regulator investor education
materials. Little attention appears to have been paid to whether the KII supports specific decision-making outcomes; testing has focused on clarity.
Nonetheless, it represents a very significant advance on the current regime.
But caution is required. The KII follows a maximum harmonization
model; successful local solutions may be prejudiced. The UK’s Reduction
in Yield indicator, for example, required in KFDs, designed to summarize
the effects of charges by means of a single figure which shows the reduction
in growth attributable to product charges, and which has tested reasonably
well,209 may come under pressure, as may similar local innovations. The
risks of disclosure as a retail market strategy also remain and should not
be sidelined; the KII alone will not address the complexity and confusion
risks generated by failures in the product market and by commission and
other risks to the quality of advice.
III. Investment product disclosure (2): the substitute
products challenge
1. A fragmented regime
a) A fragmented regime
The UCITS reform effort should not mask the risks posed by the troublesome and fragmented harmonized regime which applies to UCITSsubstitutable products. Unit-linked products are governed by a much less
208
European Commission, Impact Assessment, p. 22.
209
2008 CRA Report:
product disclosure (2): substitute products
323
extensive disclosure regime than that which applies to UCITS. The Consolidated Life Assurance Directive requires the publication of generic information concerning the insurance company and the insurance contract, but
it is not calibrated to reflect the market-facing risks of unit-linked products, although it does require an indication of the nature of the underlying
assets.210 Insurance products also fall outside the generic MiFID regime for
‘financial instruments’. Deposit-based structured products are not subject
to any discrete requirements under the current EC regime, as they fall
outside the UCITS, insurance, prospectus and MiFID regimes. Structured
securities, however, are governed by an unsatisfactory combination of the
prospectus regime and MiFID, as discussed in the following section.
b) Disclosure for ‘financial instruments’ and structured securities
The prospectus regime. Issuers of structured securities are subject to
the prospectus regime. Although the Prospectus Directive is regarded as
a retail market measure, it is issuer- rather than product-oriented and
is not designed to support the retail products market. Although discrete disclosure rules apply to different securities,211 the regime is not
calibrated to reflect the particular risks posed by complex retail investment products,212 including with respect to risk/reward profile, liquidity
risks, redemption and costs; CESR’s 2009 review of Lehman structured
products has underlined the difficulties.213 The summary prospectus
(chapter 6) is widely regarded as failing to meet retail investor needs.
National regulators are limited in tailoring the regime where difficulties arise with structured securities given the Directive’s maximum harmonization model. The Dutch AFM, which has experienced difficulties
210
211
212
213
Directive 2002/83/EC of the European Parliament and Council of 5 November 2002
concerning life assurance, OJ 2002 No. L345/1, Art. 36 and Annex III. It provides that
additional national requirements can be imposed only where necessary for proper policyholder understanding of the essential elements of the commitment (Art. 36(3)).
Specific requirements apply, for example, to derivatives and asset-based securities: Commission Regulation (EC) No. 2004/809, OJ 2004 No. L149/1, Annexes VII, VIII and XII.
‘Mass market retail products are not the obvious focus of the Directive and a prospectusbased route to market opens up consumers to real risks’: FIN-USE, Opinion on the Investment Funds Green Paper, pp. 10–11. FIN-USE has also criticized the Commission’s decision
to exclude retail investment product disclosure (and disclosure concerning retail structured securities) from its 2009 prospectus review: FIN-USE, Response to Review of Directive
2003/71 (2009), p. 3.
CESR, The Lehman Brothers Default: An Assessment of the Market Impact (CESR/09255, 2009), p. 3. CESR’s assessment included that disclosures were not always meeting
the Prospectus Directive’s Art. 5 requirement that disclosure be provided in an easily
analyzable and comprehensible form.
324
disclosure
with closed-end real estate funds, has relied on industry initiatives to
support the Directive, but progress has been slow.214 The distribution
regime is also problematic. The UCITS prospectus must be supplied
by the UCITS product provider to investors, although onward distribution through intermediaries is not satisfactory. But the prospectus
regime is based on wider publication of the prospectus to the public
(Article 14), rather than on distribution, pre-contract, to investors
(although MiFID distributors/advisers are required to make retail investors
aware where a prospectus is available where the instrument in question
is the subject of a current offer215 ).216 Regulatory arbitrage risks are considerable with respect to the detailed UCITS regime, the strenuous design
efforts in respect of which may be subverted as a result, not least as prospectus authorization, which, unlike UCITS scheme authorization, is subject
to time limits under the Prospectus Directive (Article 13), is much quicker
than UCITS authorization.217
MiFID. High-level requirements are, however, imposed on the distribution of structured securities, and on other MiFID-scope investment
products,218 including non-UCITS CISs but excluding deposit-based securities and insurance products, by MiFID’s principles-based disclosure
regime. It requires that intermediaries providing services with respect to
‘financial instruments’ within MiFID’s scope provide disclosure, including marketing communications, which is ‘clear, fair and not misleading’
(Article 19(2)). It also requires that specified pre-contractual disclosure
be provided which allows the investor ‘reasonably . . . to understand the
nature and risks of the . . . specific type of financial instrument that is
being offered’ and to take decisions on an informed basis (Article 19(3)).
Together these requirements provide the basis for a high-level disclosure
regime for investment products which eschews an instrument-specific
approach and standardization, but relies instead on investment firm determinations as to how disclosure should be presented.
The Article 19(2) ‘fair, clear and not misleading’ regime, which is
directed in particular to marketing communications, contains a number
of specific requirements at level 2 (MiFID Level 2 Directive) of particular
214
216
217
218
Commission, Record of the Open Hearing, p. 16. 215 MiFID Level 2 Directive, Art. 31(3).
ICMA (International Capital Market Association), Letter to the Commission on Review
of the Prospectus Directive and Regulation, 8 April 2008, Annex, para. 2.3, calling for the
Commission’s 2008 review of the prospectus regime to consider its alignment with MiFID.
Prospectus authorization can take from three to four weeks. UCITS authorization can
take from three to four months.
See further ch. 4. MiFID’s scope extends to many structured securities.
product disclosure (2): substitute products
325
relevance to product disclosure. Simulated returns, for example, are permitted, but are subject to the requirements of Article 27(5) with respect
to risk warnings and the construction of returns. Comparisons must be
meaningful and presented in a fair and balanced way, the source of the
information used for the comparison must be specified and the key facts
and assumptions used to make the comparison must be included (Article 27(3)). Past performance information is permitted, but restrictions
apply under Article 27(4), which is more nuanced than the earlier attempt
to address past performance in the UCITS Recommendation.219 But, by
contrast with the KII model, MiFID does not impose standardization
requirements. Similarly, the MiFID regime does not standardize projections, simply requiring that they must not be based on simulated past
performance, must be based on reasonable assumptions which are supported by objective data, that the effect of commissions and fees must be
disclosed and that they must contain a prominent risk warning that projections are not a reliable indicator of future performance (Article 27(6)).
The Article 19(3) level 2 pre-contractual disclosure regime also imposes
specific requirements with respect to financial instruments disclosure,
which must be provided in a ‘durable medium’220 (MiFID Level 2 Directive, Article 29(4)). These requirements focus in particular on risk disclosures and are to be calibrated to the type of instrument and the status
and level of knowledge of the client, although retail investors would be
expected to receive thorough risk disclosures. A general description must
be provided of the ‘nature and risks’ of the financial instrument (Article
31(1)) which must be sufficiently detailed so as to explain the nature of
the specific type of instrument concerned, and the risks particular to that
specific type of instrument, so as to enable the investor to take investment
decisions on an informed basis. The required risk disclosures (as to instrument risk, leverage risk and the risk that the entire investment might be
lost (as with capital-at-risk products), volatility and liquidity risk, financial commitments and contingent liabilities and margin requirements)
must also be relevant to the instrument and to the status and level of
knowledge of the client (Article 31(2)). Where a third-party guarantee
is provided, the disclosure provided must include sufficient information
about the guarantor and the guarantee so as to enable the investor to make
219
220
The information must not be the most prominent feature of the communication, it must
contain a prominent risk warning that past performance is not a reliable indicator of
future results, and the information should extend over a five-year period or, where the
investment has a shorter history, over its whole life span, in no case for shorter than one
year; the use of selective and potentially misleading periods is therefore prohibited.
Note 268 below.
326
disclosure
a fair assessment (Article 31(5)). The MiFID Level 2 Directive also imposes
high-level cost disclosure requirements concerning the total price paid by
the investor, including all related fees, commission, charges and expenses
(Article 33).
It may be that MiFID will drive stronger investment product disclosure ‘in action’, particularly for structured securities,221 given the overarching Article 19(2) and (3) principles. It may not be unreasonable
to suggest that firms should be better at designing product disclosure
than regulators, given their close contact with the retail investor base
and industry experience in communicating key messages effectively –
where they are appropriately incentivized to do so; the FSA has found
that marketing communications tend to be clearer and more engaging than regulated product disclosures.222 A principles-based approach
should also mitigate the risks related to obsolescence, poor investor understanding and limited investment firm engagement with how to deliver
disclosure effectively which are associated with detailed regulation, and
which have led to some regulatory enthusiasm for a principles-based
approach, and not only in the UK.223 A principles-based approach to
risk-disclosures, in particular, may drive better firm practices, particularly as MiFID does not allow for a ‘tick-the-box’ approach, but requires
firms to identify and disclose risks appropriately in accordance with
Article 19(2) and (3). MiFID’s approach also allows some considerable
room for supervisory measures designed to improve the quality of product
disclosure; the FSA’s MiFID-driven regulatory reforms to product disclosure have been supported by a range of supervisory initiatives designed to
improve the quality of KFDs, particularly with respect to length, focus and
layout, and by engagement with leading trade associations in developing
best practice guidance.224
Nonetheless, MiFID might be regarded as ill-adapted to retail-market
product-disclosure, including for structured securities. It did not experience cost/benefit analysis or market-testing and was developed in
221
222
223
224
The European Banking Federation, for example, has suggested that MiFID is driving
reforms to market standards on structured product disclosure: European Banking Federation, Response to Commission’s Call for Evidence (2007), pp. 4–5.
FSA, Good and Poor Practices, p. 7.
ASIC has adopted ‘Good Disclosure Principles’ which are designed to drive better industry practices and support investor learning and which provide that disclosure should: be
timely; be relevant and complete; promote consumer understanding; promote comparability; highlight important information; and have regard to consumer needs: Regulatory
Guide No. 168, Disclosure: Product Disclosure Statements (and Other Disclosure Obligations), p. 6.
FSA, Consultation Paper No. 06/19, p. 124.
product disclosure (2): substitute products
327
something of a vacuum. Only very limited format and delivery requirements apply.225 Although comparability is a problematic objective, standardization may be a significant casualty of MiFID’s principles-based
approach.226 Standardization of past performance information, for example, has been shown to be helpful to consumer decision-making227 and
CESR certainly appears sceptical as to MiFID’s approach.228 MiFID’s
focus on distribution also means that a gap may arise in the disclosure
chain; the fulfilment by distributors of MiFID’s requirements depends on
the availability of adequate disclosure from the product provider which
may not be forthcoming. The effectiveness of the regime also depends
on firm compliance and engagement with the core principles, regulatory/industry guidance and supervisory oversight and enforcement; the
FSA has acknowledged the importance of effective supervision in policing the new principles-based projections regime.229 But, while the FSA
has relied heavily on Principle 7 of its high-level Principles for Business
(which reflects Article 19(2) by requiring that firms must pay due regard
to the information needs of its clients and communicate information in
a way that is fair, clear and not misleading) in improving investment
product disclosure, the results, so far, are not auspicious.230 This may in
part be related to firms’ difficulties in appreciating what is required of
them, which can be challenging in a principles-based environment and
can require sophisticated and multi-layered strategies.231
225
226
227
228
229
230
231
Sect. IV below.
Albeit in the accounting context, Black has highlighted that overly flexible rules can
reduce comparability and increase information asymmetries: B. Black, ‘The Legal and
Institutional Conditions for Strong Securities Markets’ (2001) 48 UCLA Law Review 781.
The FSA has also suggested that supporting comparability across a range of investment
products may demand a more prescriptive, rule-based approach: FSA, Principles-Based
Regulation: Focusing on the Outcomes That Matter (2007), p. 10.
FSA, Standardising Past Performance (Consultation Paper No. 183, 2003).
CESR warned during the KII discussions that, while the MiFID standards were a starting
point, they were not sufficiently detailed to ensure consistency and to prevent consumer
misunderstanding: CESR KII Advice 2008, pp. 29 and 42.
The FSA argued that any risk of consumer detriment raised by MiFID’s principles-based
approach to projections could be addressed by supervision: Consultation Paper No. 06/19,
p. 125.
The FSA has found that, while many firms met the relevant formal disclosure requirements,
the resulting disclosure did not meet the over-arching requirements of Principle 7: Good
and Bad Practice, p. 6.
The FSA’s KFD strategy is based on a series of elements (n. 148 above). In support of
better financial promotions, it has adopted a multi-stranded approach based on education,
deterrence, prevention and confidence strands (Discussion Paper No. 08/3, pp. 46–7) as
well as on promotions forming a part of its Retail Market Thematic Reviews: FSA, Major
Retail Thematic Work Plan 2008–2009, p. 7.
328
disclosure
The FSA’s experience with the MiFID disclosure regime is instructive
as to its risks and benefits. The FSA requires a KFD and a Key Features
Illustration (which covers the effect of charges as well as projected performance and which can be included within the KFD232 ) to be prepared by
producers of packaged products. These documents must be provided by
firms which sell and advise on these products to retail clients at the point
of sale.233 UCITS providers and those selling UCITS can meet the KFD
production and delivery requirements by means of the UCITS simplified
prospectus regime.234 The FSA made a successful Article 4 application
to retain its KFD/simplified prospectus delivery requirements in respect
of UCITS investments and KFD preparation and delivery requirements
for non-UCITS products (MiFID does not expressly require that investment firms must provide UCITS investors with a simplified prospectus or that product disclosure be delivered in a specified, standardized
form). The FSA has therefore retained its standardized KFD content,235
format236 and delivery (at the point of sale) requirements. Despite the
232
233
234
235
236
The effect of charges information takes the form of a Reduction in Yield requirement
(a statistic which shows the impact of initial and ongoing charges on growth over a tenyear period (i.e. it would show that, while x per cent growth is expected, in real terms it
would be y per cent)) and an Effect of Charges Table, which shows the effect of charges
after one, three, five and ten years: COBS 13, Annex 3.
COBS 13.1.1 and 14.2.
COBS 13.1.3 and 14.2.7 exempt UCITS units from the KFD production and delivery
requirement where the simplified prospectus is used. Non-UCITS schemes may follow
the simplified prospectus model, which is broadly similar to the KFD, with respect to
production and delivery requirement (COBS 13.1.3 and 14.2.7). The simplified prospectus
regime, based on the UCITS Directive, is set out in the Collective Investment Sourcebook
(COLL) (COLL 4.6) which includes the KII Reduction in Yield and Effect of Charges
requirements but which does not follow the prescriptive KFD format requirements. Firms
may use the FSA’s ‘key facts’ logo (required for KFDs), as long as the regulatory ‘boiler
plate’ required of KFDs with respect to the FSA’s requirement for the disclosure and its
importance is used.
The KFD must include enough information about the nature and complexity of the
product and how it works, any limitations or minimum standards that apply and the
material benefits and risks of the product, such that the retail investor can make an
informed decision, include information on complaints handling (which is not required
under MiFID), and include charges information and projections in the Key Features
Illustration (COBS 13.3.1 and 13.4.1).
The KFD must display the FSA’s ‘keyfacts’ logo and the firm’s brand, and include required
regulatory ‘boilerplate’ with respect to the KFD being required by the FSA and representing
an important document which should be read carefully (COBS 13.2.2). Packaged product
KFDs must also follow a prescribed format based on: title of product; description; its
aims; ‘your commitment’/‘your investment’ (explaining the nature of the commitment or
investment and the consequences of failure to maintain it); risks; and a Q and A section
product disclosure (2): substitute products
329
Article 4 application, the KFD requirements have nonetheless been significantly diluted by the FSA, reflecting MiFID’s principles-based model,237
and a number of standardization requirements removed, particularly with
respect to past performance, risk warnings (which has led to a significant
thinning out of the previously detailed FSA regime concerning ‘customers
understanding of risk’238 ) and projections.239 The FSA expressly supported
MiFID’s principles-based approach and, in particular, MiFID’s eschewal
of standardization for past performance disclosures,240 despite some resistance from its Financial Services Consumer Panel.241
The FSA’s Article 4 application is closely related to the particular features
of the UK packaged product market. But, in its concern to maintain a
degree of standardization, it reflects risks as to confusion and conflict of
interest which are increasingly common to domestic markets across the
EC, and regardless of whether advice is provided by the commissionbased advisers, which dominate in the UK market, or by banks advising
on proprietary products, common in continental Europe. The FSA argued
that reliance on MiFID’s non-standardized principles alone would mean
the loss of a ‘key regulatory tool’ for dealing with information asymmetries
and would prejudice comparability. It also argued that standardization was
necessary given the predominance of packaged and substitute products in
237
238
239
240
241
(on the principal terms of the product, what it will do for the investor and other information
necessary to help a retail investor make an informed decision): COBS 13.3.2.
FSA, Conduct of Business Regime: Non-MiFID Deferred Matters (Consultation Paper
No. 07/9, 2007), pp. 58–60; and FSA, Reforming Conduct of Business Regulation (Policy
Statement No. 07/6, 2007), pp. 77–9. The FSA has replaced many of its detailed KFD
requirements (including for non-MiFID-scope products such as insurance products)
with high-level MiFID rules.
FSA, Consultation Paper No. 06/19, pp. 123 and 130–1. Detailed requirements for warrants
and derivatives, retail securitized derivatives, non-readily realizable investments, penny
shares, securities that may be subject to stabilization, stock-lending activities, listed and
geared securities and structured capital-at-risk products have been removed.
The FSA embraced the MiFID approach (for MiFID and non-MiFID firms) as reflecting its
principles-based strategy: ibid., pp. 119–25. Standardized requirements remain in place,
however, for non-MiFID packaged products (life insurance products) (COBS 13.4).
The FSA removed its standardization requirements, partly given concerns as to international regulatory arbitrage were it to maintain a more restrictive regime but also in
support of MiFID’s ability (with FSA guidance) to address investor risk: FSA, Financial
Promotions and Other Communications (Consultation Paper No. 06/20, 2006), p. 21. It
also highlighted that it was keen to reduce the emphasis on past performance information,
which was supported by MiFID’s approach (ibid., p. 15).
The Panel regarded the standardization of past performance information as valuable and
its removal as a disappointment, and called on the FSA to monitor market and investor
reaction: FSCP, Consultation Paper CP 06/19 and CP 06/20, Reforming Conduct of Business
Regulation (2006), p. 2.
330
disclosure
the UK market, the range and complexity of these products, the risk
of information asymmetries, heightened by agency risks in the advice
relationship from commission-based advisers, and the benefits which, the
FSA argued, standardization brings to investor understanding in terms
of the removal of uneven and inconsistent disclosures.242 Many of these
arguments resonate with the risks raised by substitute products and sales
of proprietary products across the Member States.
2. Developing a response
This fragmented EC investment product disclosure regime sits uneasily
with the reality that products which substitute with UCITS, and particularly non-UCITS schemes (including alternative-investment-based
schemes), structured products and unit-linked insurance products, can
be highly complex and popular with investors. Disclosures may, however,
be inadequate or not present key risk information clearly, as has been highlighted with respect to structured products internationally243 and in markets across the EC including the Danish,244 Dutch,245 French,246 German247
and UK248 markets, and by the impact of the Lehman collapse on capitalprotected structured products.249 Although comparability is a troublesome objective, retail investor stakeholders are concerned as to a lack of
comparability across the universe of investment products.250 Regulatory
242
243
244
245
246
247
248
249
250
UK Article 4 Application, p. 20.
The Hong Kong Securities and Futures Commission has reported that retail investors did
not fully understand the nature of structured products and that only 11 per cent of investors
recalled having received, read and fully understood the relevant offering documents:
Securities and Futures Commission, Investors Lack Understanding of Structured Products
(2006), p. 2.
The Danish market has seen concerns as to disclosure concerning the costs of indexlinked bonds and their option components: A.-S. Rang Rasmussen, ‘Index-Linked Bonds’
in Danish Central Bank Monetary Review, Second Quarter 2007 (Danish Central Bank,
2007), p. 51, p. 58.
AFM, Exploratory Analysis of Structured Products (2007), pp. 37–8.
Delmas Report, pp. 9 and 20–3.
BaFIN, Annual Report 2006, p. 27, warning that investors can no longer assess the core
profit and risk characteristics of certain products.
FSA, Financial Risk Outlook 2008, p. 51 (warning of transparency and confusion risks).
D. Waters (FSA), Speech on ‘Industry Response to Developments in Regulation of
Structured Products’, 12 February 2009, available via www.fsa.gov.uk/Pages/Library/
Communications/Speeches/index.shtml, noting the FSA’s examination of the quality of
marketing materials and risk disclosures in the products affected.
The leading European consumer association, BEUC, has called for the same level of
information to be made available for products which meet the same need: European
product disclosure (2): substitute products
331
arbitrage risks are also significant. The variable treatment of cost disclosure
under the fragmented UCITS/MiFID/prospectus/insurance regimes,251
and the ability of product providers to avoid more stringent requirements by constituting products slightly differently, has been identified
as a particular risk to retail investors252 with costs often buried in nonUCITS products.253 Even assuming that disclosure must be discounted as
a regulatory strategy, or, at the very least, carefully embedded within a
matrix of product design, distribution and investor education strategies,
the weaknesses in the disclosure regime for the wider universe of investment products mean that disclosure struggles all the more in enhancing
the investor decision and that greater stress is placed on distribution and
design strategies.
The difficulties in designing a harmonized response are, however,
considerable, even leaving aside industry tensions with respect to any
rollout of the UCITS KII model254 and the inherent difficulties of
disclosure design. The complexities of structured products, for example, might be difficult to capture in a two-page KII-style summary
which might also lead to moral hazard risks for the inexperienced
retail investor. Comparability is not always achievable or even desirable
where products have distinct features. Investment products are often
designed to reflect path-dependent local market influences; local disclosure requirements, supported by the Article 4 exemption for MiFID
disclosures, may be more effective in addressing disclosure risks, particularly given limited cross-border product marketing. National regulators are testing and developing cross-product models, often based on
251
252
253
254
Consumers’ Organization (BEUC), Response to the Commission Green Paper on Retail
Financial Services (2007).
The UCITS Directive requires disclosure of entry and exit commissions, while the Simplified Prospectus Recommendation recommends more detailed disclosure of costs, including that costs be presented through a Total Expense Ratio (TER) figure and that soft
commissions be disclosed. The Consolidated Life Assurance Directive does not impose
specific cost requirements, while the prospectus regime focuses on issuer disclosure and
does not address the implications of a product’s cost structure. The MiFID regime imposes
only high-level requirements.
Rasmussen, ‘Index-Linked Bonds’, 58.
B. Aboulian, ‘Brussels Mulls Common Information Form’, Financial Times, Fund Management Supplement, 16 February 2009, p. 11.
Well illustrated by the contrasting contributions to the debate of EFAMA (arguing for the
KII to be the benchmark for all retail products) and the European Derivatives Association
(suggesting that product features could not be presented in a comparable or standardized
way for all products): Commission, Minutes of the Industry Workshop on Retail Investment
Products (2008), pp. 6–7.
332
disclosure
the UCITS model;255 the KII model might be expected to drive further
national reforms. Considerably greater experience is also needed with
the MiFID disclosure regime for financial instruments. Industry efforts
should also not be discounted, particularly with respect to structured
products.256
On the other hand, experience with the 2004 UCITS Recommendation
does not augur well for the emergence of a consistent approach in the
absence of harmonization. Extensive harmonization of product disclosure across the universe of investment products is neither practical nor
desirable and has been rejected under both the MiFID and the UCITS KII
models. But significant gaps remain, particularly with respect to structured deposits, but also with respect to unit-linked insurance. The design
technology has improved immeasurably following the KII experience. The
resources demanded by investment product disclosure design also suggest
that economies of scale, particularly for less well-resourced and experienced regulators, could follow from harmonization. Overall, the wider
policy effort to build an informed and competent retail market should
arguably not be a hostage to the incremental manner in which the EC
investor protection regime has developed and the original focus on the
UCITS product.
Cross-product disclosure harmonization appears to be the emerging
policy preference, although a long battle may lie ahead with the industry.
As outlined in chapter 3, the Commission, in response to the substitute
products debate, has proposed a radical recasting of the harmonized disclosure regime such that a coherent regime would apply to all ‘packaged
products’;257 it appears that the relevant UCITS, prospectus, insurance
and MiFID regimes may be repealed and replaced by a horizontal instrument. The regime, which, unlike MiFID, would apply at the ‘factory gate’
to all product providers, would be designed to achieve as great a degree
255
256
257
The UK KFD regime applies to a range of packaged products, although it does not cover
structured notes: COBS 13.1.1.
Including the Dutch Banking Association’s (the NVB) best practice principles for structured products disclosure (NVB, Recommendation LC-346, February 2007), the German
Code of Conduct (Derivate Kodex), which addresses structured product disclosure and
the codes of conduct which have been adopted by the UK insurance industry. Internationally, the Joint Associations Committee (the ESF, CMA, ISDA and SIFMA) have addressed
disclosure in their Retail Structured Products: Principles for Managing the Distributor–
Individual Investor Relationship (2008).
European Commission, Communication from the Commission to the European Parliament
and the Council: Packaged Retail Investment Products (COM (2009) 204) (‘Packaged Products Communication’).
disclosure in the distribution and advice context
333
of harmonization and standardization as possible; its coverage is envisaged as including the ‘fair, clear and not misleading’ principle, specific
and standardized information requirements (including with respect to
performance, risks, charges, guarantees and product functioning), standardized format requirements and related requirements for marketing
communications.258 The UCITS KII is to be the model for the new regime.
While this reform is at a very early stage, the risks259 are considerable given
the level of detail which appears to be envisaged.260 While the achievements
of the UCITS KII are considerable, it is specific to a particular product and
it is not at all clear that it can be easily rolled out across the investment
product sector. Comparability is sought by the reforms,261 but it will be
very difficult to achieve. A less ambitious regime, which would sacrifice
standardization but focus on the achievement of ‘fair, clear and not misleading’ disclosures, might achieve better results. A holistic approach is
certainly required. Costly harmonized disclosure will be of limited use
in the absence of an integrated investor education strategy. Appropriate
attention by product providers to the design and targeting of retail market products would also provide a more substantial bulwark for the retail
market, while effective investor choice remains primarily a function of the
related sales and advice process.
IV. Disclosure in the distribution and advice context
1. Marketing communications
The firm-facing rules which govern the marketing of investment services
and products (chapter 4) are supplemented by disclosure requirements
for marketing communications. Reflecting an investor protection model
which assumes high levels of competence but which, as a creature of its
time, does not probe how disclosure ‘in action’ can support vulnerable
but engaged investors, the DMD is heavily based on investor-facing, precontract disclosure requirements concerning the firm, the distance service,
the contract, risk warnings and (unlike MiFID) redress (Article 3). Most of
these requirements have, for MiFID services and instruments at least, been
258
260
261
Ibid., pp. 9–10. 259 See further ch. 3.
Although at an earlier stage the Commission was careful to highlight that, while some
degree of alignment might be appropriate, full comparability was neither practical nor
desirable: European Commission, Industry Workshop, p. 8.
And was highlighted in the related Impact Assessment (SEC (2009) 556), pp. 13 and 24.
334
disclosure
overtaken by MiFID’s disclosure requirements.262 Delivery obligations are
imposed, although formats are not addressed: the supplier must communicate to the consumer all the contractual terms and conditions, and the
required disclosures, on paper or, with respect to non-paper communications, on another ‘durable medium’,263 in good time before the consumer
is bound by any distance contract or offer (Article 5(1)). Additional but
basic disclosures for online transactions are required by the E-Commerce
Directive,264 while MiFID, as discussed in chapter 4, imposes a principlesbased regime for marketing (and all other) communications265 under
Article 19(2) by requiring that all information which is addressed by an
investment firm to clients or potential clients must be ‘fair, clear and not
misleading’.
2. General investment firm and services disclosure:
MiFID Article 19(2) and (3)
The Article 19(2) requirement that communications be ‘fair, clear and not
misleading’ governs all communications between the firm and the investor,
including those made in providing advice. More specific requirements
are imposed by Article 19(3) (amplified by the MiFID Level 2 Directive,
Articles 29–34) and by the level 2 inducements regime (MiFID Level 2
Directive, Article 26), which require firms to provide appropriate information ‘in a comprehensible form’ to clients and potential clients about
the firm and the services provided, the financial instruments involved, the
proposed investment strategies, including risk warnings and execution
venues and the related costs and associated charges.
Although the level 2 firm/services disclosure regime (and the level 2
regime for financial instruments disclosure) applies to retail investors
262
263
264
265
Where provisions of Community law governing financial services contain additional prior
information requirements, those requirements apply (Art. 4(1)).
Any instrument which enables the consumer to store information addressed personally to
him in a way accessible for future reference for a period of time adequate for the purposes
of the information and which allows the unchanged reproduction of the information
stored (Art. 2(f)). This could include website disclosure, but only as long as the Art. 2(f)
conditions are met.
Directive 2000/31/EC of the European Parliament and of the Council of 8 June 2000 on
certain legal aspects of information society services, in particular electronic commerce, in
the internal market, OJ 2000 No. L178/1.
‘Marketing communication’ is not defined but can be distinguished from a personal
recommendation which is defined as investment advice (MiFID Level 2 Directive,
Art. 52).
disclosure in the distribution and advice context
335
only (MiFID Level 2 Directive, Article 29(1) and (2)),266 MiFID does
not address processability risks. An attempt to address processability
is implicit in the over-arching Article 19(2) requirement that all communications be ‘fair, clear and not misleading’, while Article 19(3)
requires that information be provided in a ‘comprehensible form’ and
that the investor be ‘reasonably able’ to understand the risks and take
investment decisions on an ‘informed basis’. If MiFID’s principles-based
approach succeeds in focusing firms on outcomes, and this must be
questioned given the resources and expertise which the FSA experience suggests are necessary, it has the potential to drive better disclosure in the advice and distribution context. But no attempt is made
to address how the outcome of informed decision-making might be
achieved.
MiFID’s approach to format, for example, is troublesome. Firms may
provide key disclosures (including product disclosures) in the midst of
their terms and conditions or through general website disclosures; key
disclosures may be obscured across different documents, particularly as
nothing in the Level 2 Directive requires the level 2 disclosure to be provided ‘immediately and at the same time’ (recital 49). Firms must simply provide the terms of the agreement, and the Article 19(3)-related
specific level 2 information concerning the agreement or the service in
question ‘in good time’, either before the client is bound by the agreement or before the provision of services (whichever is the earlier) (MiFID
Level 2 Directive, Article 29(1)).267 Firms therefore enjoy considerable
flexibility in how they provide the required disclosures, subject to the
requirement that the disclosures are provided in a ‘durable medium’.268
By contrast with the DMD, but in a firm-facing attempt to defray costs,
disclosure may also be made by means of a website, even where the website
does not meet the requirements for a ‘durable medium’, although conditions apply (MiFID Level 2 Directive, Article 29(4)) and firms are somewhat restricted in when they can use non-paper communications (MiFID
Level 2 Directive, Article 3(2)). While the over-arching requirement that
266
267
268
Professional investors who can contract for protections are only required to be supplied
with specified information concerning client asset protection.
The other disclosures required under Arts. 30–33, including costs disclosure, can be
provided later, but in good time before the provision of services (Art. 29(2)).
Any instrument which enables a client to store information addressed personally to the
client in a way accessible for future reference for a period of time adequate for the
purposes of information which allows the unchanged reproduction of the information
stored (MiFID Level 2 Directive, Art. 2(2)).
336
disclosure
disclosure be fair, clear and not misleading provides supervisors with the
means for demanding better disclosure practices, and should provide some
incentives in terms of increased liability risks, this depends on the effectiveness of local supervision and on supervisory convergence through
CESR; greater prescription by MiFID might have delivered quicker
results.
The litany of level 2 firm/services disclosure required also reflects a
regime based on disclosure ‘on the books’ and not on disclosure ‘in action’.
The generic requirements (MiFID Level 2 Directive, Article 30) form a
catalogue of basic disclosures concerning, for example, the languages and
methods which may be used for communication, the firm’s authorization status, whether it is acting through a tied agent, the ongoing reports
required under MiFID and a summary description of the firm’s conflictof-interest policy and asset protection arrangements. Even allowing for
the limitations of a catalogue of this nature, it is incomplete; disclosure
is not required with respect to redress, including out-of-court redress
mechanisms, notwithstanding the increasing prominence of redress
(chapter 8).
Specific disclosure requirements are imposed under Article 31 of the
MiFID Level 2 Directive which, in addition to financial instrument risk
disclosure (section III above), also governs risk warnings for investment
services more generally. Article 32 addresses asset protection arrangements, supported by Article 43 on reporting requirements. A troublesome best execution disclosure regime applies to execution services, while
the execution-only regime is supported by a disclosure regime which
must carry out some very heavy lifting with respect to investor protection
in advice-free, execution-only services (chapter 6). An extensive regime
applies to the asset/portfolio management services which represent a small
subsection of the wider EC retail market, the extensive range of which sits
uneasily with the reality that asset management clients are more likely to
be sophisticated investors able to bargain for information. For those more
sophisticated retail investors who rely on asset managers, MiFID’s catalogue of information (Article 30(3)) reflects the ‘disclosure on the books’
approach. In a more proactive, although controversial, attempt to encourage investor monitoring, the firm must, however, establish an appropriate
method of evaluation and comparison, such as a meaningful benchmark,
which enables the client to assess the firm’s performance (Article 30(2)).
Extensive periodic reporting requirements are also imposed (Article 41).
The nature of the disclosure required, including with respect to contingent liabilities (Article 42), suggests, however, that the regime, while
disclosure in the distribution and advice context
337
notionally directed towards retail investors, is designed for a sophisticated
and competent subset of that market.
Balance is required. Disclosure design represents one of the most difficult challenges for regulators, and MiFID was never likely to support
radical, harmonized innovation in investment firm disclosure design –
although it did produce one intriguing innovation: the Commission’s first
working draft on the MiFID conduct-of-business regime, and ‘as an alternative to traditional methods by which information is communicated’,
proposed an investor aptitude test, which was designed to ‘explore a more
effective and targeted solution’ and would have allowed qualified investors
to choose to opt out of aspects of the disclosure regime.269 Although the
innovation did not survive to the second working draft, it remains a tantalizing example of the Commission’s willingness to explore more radical
options.270 MiFID’s limitations were, however, exacerbated by the failure
to engage in any ex ante testing of the new regime, which is in part a
function of the political cauldron within which MiFID was developed but
which nonetheless stands in sharp contrast with the KII model.
The specific risks covered by MiFID also suggest some misallocation of disclosure resources. Disclosure requirements in the investment
firm/investor context might be regarded as having two main preoccupations in the mass market: product disclosure; and, given the prevalence
of commission risk, conflict-of-interest-related disclosure. But asset management and brokerage services appear to be the main targets of the
current MiFID regime. As discussed in section III above, it is not clear that
it supports an adequate disclosure regime for MiFID-scope investment
products, and the resilience of MiFID’s disclosure regime for commission
risk is also questionable, as discussed in the next section.
3. Conflicts of interest and commissions
a) General disclosure requirements
As discussed in chapter 4, conflict-of-interest risk is an entrenched
retail market risk. MiFID’s conflict-of-interest regime, including its
inducements regime, is largely based on firm-facing, conduct-shaping
269
270
ESC/23/2005, Art. 9 and July 2005 Explanatory Note (ESC/24/2005), p. 2. The test was
designed to establish that the investor was sufficiently knowledgeable and had an adequate
understanding of financial markets. CESR was charged with developing the test.
For a more radical application of investor testing (in the context of restricting investor
access to the market unless they display sufficient competence) see S. Choi, ‘Regulating
Investors Not Issuers: A Market-Based Proposal’ (2000) 88 California Law Review 279.
338
disclosure
rules and as such eschews, to some extent, the disclosure-based attractions of the empowerment/responsibilization models. But disclosure is
also relied on as a back-stop measure for addressing general conflict-ofinterest risk and may also have some potential as a long-term investor
education technique. There are, however, risks to MiFID’s approach.
MiFID does not require a firm to refrain from acting where it cannot
prevent prejudice to the investor’s interests disclosure is the back-stop
protection. Where the MiFID-required organizational arrangements are
not sufficient to ensure ‘with reasonable confidence’ that ‘risks of damage
to client interests will be prevented’, the firm must ‘clearly disclose’ the
‘nature and/or sources’ of the conflict to the client before the firm undertakes business on its behalf (Article 18(2)). At level 2, some attempt is
made to support processability with the requirement that the disclosure
be made in a durable medium and include ‘sufficient detail’, taking into
account the nature of the client, to ensure the client takes an ‘informed
decision’ with respect to the investment services subject to the conflict
of interest (Article 22(4)); boilerplate disclosure of generic conflicts will
not be sufficient. The decision to disclose remains, however, with the firm
and is governed by subjective determinations as to the nature and likelihood of damage to client interests; damaging conflicts may arise about
which the investor has no knowledge. Unless the firm has determined
that disclosure is required, the only disclosure received is the summary of
the firm’s conflict-of-interest policy (MiFID Level 2 Directive, Article 30).
Even where a conflict is disclosed, it is not clear whether the client’s express
consent to proceed is required, although Article 22(4) requires that the
disclosure enable the client to take an ‘informed decision’ with respect
to the investment service given the conflict of interest. A more robust
approach might have required investor consent to the firm proceeding. If
a conflict is of such a magnitude that it cannot be managed by organizational arrangements, disclosure to the retail investor is unlikely to manage
the risks.
b) Commission risk and services and costs disclosure
Disclosure also forms part of MiFID’s arsenal for managing commission
risk. It may be that commission risks and investor confusion as to the
real costs of investment advice demand a multi-faceted approach, including disclosure. Investor-facing disclosure efforts to encourage investors
to ‘know their adviser’,271 and to understand the nature and cost of the
271
Deaves Report, p. 307.
disclosure in the distribution and advice context
339
service provided certainly remain popular;272 they have remained a feature of the FSA’s imaginative RDR.273 As long as it does not supplant
firm-facing requirements and transfer the risk monitoring burden to
the investor, disclosure of this type holds some promise for long-term
investor competence. But disclosure techniques are particularly problematic as an immediate response to commission risk given severe competence
difficulties;274 despite, for example, strenuous FSA disclosure efforts, in
practice, investors often remain unaware of remuneration structures.275
Prior to MiFID’s adoption, the Insurance Mediation Directive used disclosure to grapple with the delivery of objective advice. It requires that an
insurance intermediary inform the customer whether advice is given in a
context in which the intermediary is tied to one or more insurance undertaking, gives advice based on the obligation to provide a ‘fair analysis’,276
or is not tied but does not give advice on the basis of a ‘fair analysis’
(Article 12(1)). But MiFID’s principles-based model does not impose
specific disclosure requirements concerning the adviser or the status of
advice. MiFID Article 19(2) and (3) might, however, suggest that statusrelated disclosure277 to the effect that a limited range of products, or only
272
273
274
275
276
277
Australia’s 2001 Financial Services Reform, for example, introduced a ‘statement of advice’
requirement which required investment firms/financial planners to provide a statement
which included the commission received and any associations which might reasonably
be expected to be capable of influencing the advice: Australian Treasury, Refinements to
Financial Services Regulation: Proposals Paper (2005). In The Netherlands, and pre-MiFID,
the 2006 Financial Supervision Act included rules on the transparency of remuneration
and commission: AFM, Brochure – The Most Important Amendments to the Supervision of
Conduct following the Introduction of the Wft (2006). The UK has made repeated attempts
to address commission disclosure, as outlined below.
Amidst the swingeing structural changes to ‘advice’ and ‘sales’, the FSA has continued
to rely on charges disclosure while acknowledging that ‘providing the right information
to consumers to help them make informed choices is not a straightforward task’: Retail
Distribution Review (Feedback Statement No. 08/6, 2008), p. 60.
The Australian experience has been that not all consumers are able to use disclosures to
judge the impact of conflicts on advice: ASIC, Shadow Shopping on Superannuation Advice:
ASIC Surveillance Report (2006).
Twenty-eight per cent of those surveyed in one study did not know how advisers were
remunerated, while 11 per cent of those who had used an adviser were unaware of the
structure of remuneration: Financial Risk Outlook 2007, p. 96. An RDR-related study also
found ‘very little understanding’ of commission disclosure: Accessing Investment Products:
Consumer Perceptions of a Simplified Advice Process (Consumer Research No. 73, 2008),
p. 24.
See further ch. 4 on the Directive (Directive 2002/92/EC OJ 2003 No. L9/3).
Disclosure of this sort has formed part of the FSA regime for some time. The FSA’s
2008 guidance for a new stand-alone ‘Services and Cost Disclosure Document’ (SCDD),
which forms part of the FSA’s implementation of MiFID, Art. 19(2) and (3), explains
340
disclosure
etary products, are ‘advised on’ would be required to avoid misleading the
investor and to ensure that risks are reasonably understandable. MiFID
Article 19(3) expressly requires that costs disclosure be provided, while
Article 33 of the Level 2 Directive requires that the ‘total price’ to be paid
by the client, including all related fees, commissions, charges and expenses,
and all taxes payable by the investment firm, must be disclosed. But this
provides only a shaky foundation278 for the effective disclosure of cost and
commission structures. Disclosure is also required, in summary, of the
firm’s conflicts-of-interest policy (Article 30(1)(h)), but this is unlikely to
drive investor awareness of potential bias.
Some sharp light has been thrown on potential inadequacies in the
MiFID services and costs regime by the FSA’s attempts to implement
MiFID’s requirements. While rooted in the UK experience, it has some
relevance for the wider EC market given growing concerns as to investor
inability