MiFID – the legal perspective

MFID is the biggest change to impact on investment firms since the Investment Services Directive (ISD) of 1993. Undoubtedly it will present some major challenges and opportunities for EU financial service investment firms, from broker- dealers and asset managers to corporate finance advisors.

Although back in November 2005, the FSA advised firms to “start planning now to meet the implementation challenge,” there is little evidence that organisations have started to get their houses in order. From a legal point of view, firms are in danger of leaving themselves vulnerable to risk and breaches of the FSA rules if they fail to prepare properly for MFID.

So what exactly is MFID? In a nutshell, it is part of the European Union’s Financial Services Action Plan, which has been designed to create a single European market in financial services.

So what are the benefits of MFID and how will it affect companies? One of the key aims behind MFID and indeed ISD before it, was to give a ‘passport’ to investment firms to enable them to provide pan European services and establish operations in other member states. This will allow them to provide services across the EU and establish branches in other European member states. And the scope of MFID is wider than ISD as it broadens the range of core investment services that can be passported – for example, MFID extends the scope of the passport to cover commodity derivatives, credit derivatives and financial contracts for differences for the first time. Therefore, from a new business perspective for financial service investment firms, it could prove very beneficial indeed.

MFID also aims to harmonise regulation governing both the organisation and conduct of business at investment firms, and the way markets operate. In addition, most firms that have to adhere to MFID will also have to comply with the new Capital Markets Directive, which will set requirements for the regulatory capital that a firm must hold. MFID also does away with the idea that all share trading has to be conducted through exchanges. A lot of financial organisations deal ‘off book’ meaning that they can shift shares they already hold between the customers that want to buy and sell, which is easier than going through exchanges – MFID makes this possible.

In the UK the FSA has already warned companies that they need to start preparing for MFID so they are ready for next year’s implementation deadline. Within finance companies, the responsibility lies with senior management, to get to grips with the issues and challenges that their organisations may face in the run up to MFID.

According to the FSA, the factors that will be of critical importance are organisational structure; governance; procedures and policies and trading and infrastructure. However, the changes that MFID will cause will not only be aligned to these major functions, but to a host of other organisational functions such as client services and management; marketing; risk management and of course, legal. MFID also establishes a common conduct of business practices. These are essentially geared towards the introduction of a new client categorisation regime; the marketing of a firm’s services (having an impact on the existing UK financials promotions regime); the information that is held about the firm and the services; and recording and documenting client agreements.

So from an organisational perspective and ultimately, from a legal perspective, how can firms get their houses in order to guarantee compliance to MFID once the deadline comes around? New technology and revamped systems and processes will underpin the majority of initiatives that are geared towards MFID compliance. For example, the fact that firms will have to be able to prove “best execution on deals” will have to take into account issues such as price, venue, cost and speed. Firms will therefore be obliged to keep records for up to five years. Currently, very few firms that trade ‘off book’ have the requisite systems to record and store the information and prove that they are providing the best execution of deals as they will be compelled to do under MFID. So getting the right systems in place is something that firms will have to start thinking about soon.

MFID also requires companies to publish a greater quantity of information than they did in the past, which will mean them having to implement a new or updated communications infrastructure and in order to do this, they will have to build new business processes. Analysts are predicting that spend on IT and new processes will cost the industry around UK£1 billion.

The operational changes that will have to be made within businesses are likely to arise from the organisational, conduct of business, transparency and transaction reporting requirements of MFID. These requirements will cover a number of issues, most of which are governed by technology and all of which will require sound legal and contractual practices around them.

These requirements are geared around: compliance arrangements, including measures governing personal transactions; internal systems and controls in relation to business continuity, staff, risk management; internal systems and IT systems and processing, amongst other things. Firms will need to consider a number of factors, including the efficiency and effectiveness of their arrangements for compliance and risk management; the integrity of their systems and their arrangements for identifying conflicts of interest. According to the FSA, it is likely that there will be an increase of firms’ functional independence of compliance and risk management controls – this will lead to reviews of companies’ internal organisation; their reporting structures and the allocation of responsibility to management. This would all be catered for if thorough requirements analysis was conducted and all processes were properly documented and mapped.

From the legal perspective, considering that preparation for MFID is about to kick-start significant organisational change and re-structuring, firms have to be aware that they have the necessary legal processes and precautions in place before embarking upon change. Planning for MFID implementation should include ensuring legal contract and due diligence issues are considered in relation to the IT procurement and consultancy work that is required for compliance. This will help investment companies to reduce potential legal risk exposure and to control budget and costs. Firms will also have to ensure that any contractual issues around procurement and consultancy are airtight – factors such as risk and requirements are always changing, so the contract needs to be flexible enough to allow for this. The contract should also cover for every eventuality, good or bad, in procurement or consultancy situations.

Firms also need to plan and be aware of the prescribed rules introduced by MFID in relation to the outsourcing of operational functions to a third party – these will relate to the outsourcing of ‘critical and important functions’ and possibly the outsourcing of investment services. Firms will need to ensure, from a contractual perspective, that all existing outsourced arrangements will meet MFID’s relevant requirements.

So with MFID set to fundamentally change the way firms operate in the finance space, a number of trends will emerge. Industry watchers predict that MFID might kick start consolidation in the marketplace of smaller providers, with firms believing that banding together will ease the load when it comes to meeting the stringent requirements of MFID. Another is that competition with regards to recruiting the best staff, able to oversee and effectively manage companies’ transition to MFID will intensify.
Whatever the future outcomes of the Directive, firms have to take on board what they need to do now and have to carefully consider their legal position when it comes to MFID compliance. Whether this pertains to the changes in marketing requirements, or the reporting of information, firms have to be well aware of the prescribed rules. Careful planning and failsafe control for MFID implementation is required well in advance of 1 November 2007 – this will ensure that firms are legally covered in the run up to compliance, and that at the end of the day, the costs of compliance of MFID do not outweigh the business benefits.

Andrew Rigby is a partner in the Financial Services Technology and Outsourcing group at Addleshaw Goddard www.addleshawgoddard.com.