Markets in Financial Instruments Directive – MiFID

MiFID recognises three types of clients:

(1) professional,
(2) retail, and
(3) counterparty.

The greatest regulatory protections are afforded to retail clients. 

A professional client is a person that satisfies the criteria set forth in Annex II of the Directive. A retail client is any person not deemed a professional client. Eligible counterparties are defined by Member States. However, per se eligible counterparties are investment firms, credit institutions, insurance companies, UCITS, pension funds, and governments. The classification scheme triggers the level of protection investment firms are required to provide through the conduct of business rules. Noteworthy is the fact that a client’s classification status is fluid depending upon the nature of the transaction and the partitioning scheme found in the Directive.

Annex II defines a professional client as “a client who possesses the experience, knowledge and expertise to make its own investment decisions and properly assess the risks that it incurs.” Section I then defines by default clients deemed to be professional clients. This partitioning covers mainly institutional investors that do not need consumer level protection. However, Annex II provides for two exceptions: (1) opt-down and (2) opt-up. A client defined as a professional client by default may request to be treated as a retail client for certain transactions and therefore opt-down for greater investor protection. By contrast, a person not falling within the default category of professional client may request to be treated as a professional client. A firm does not automatically honour a request. Rather, Section II of Annex II sets forth the procedure to be followed to permit a person to opt-up to the status of a professional client.

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“In particular, the firm may opt a client up only if it has assessed the client’s expertise and knowledge and is satisfied that the client is capable of making its own investment decisions and understanding the risks involved regarding the types of transactions and services envisaged. During this assessment, the firm must be satisfied that at least two of the following criteria are satisfied” (Freshfields Bruckhaus Deringer, MiFID: Customer Classification, Suitability and Appropriateness, Briefing April 2006):

•  The client has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters, or
•  The size of the client’s financial instrument portfolio, defined as including cash deposits and financial instruments exceeds EUR 500,000, or
• The client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged (Annex II.1 of the Directive)  

If the client is neither a professional client nor counterparty, then the client is considered a retail client subject to suitability and appropriateness requirements. The Level 2 Directive provides in detail the requirements a firm must follow to meet its investor protection obligations to a retail client.  Article 19(6) contains an important exception for retail clients that seek to execute trades in non-sophisticated instruments on regulated markets (E.g., In the United States, an $8 commission for a retail trade is commonplace. At current exchange rates, that commission equals about 5 EUR. Intuitively, equivalent fees for trades in Europe appear unlikely). The firm is relieved of the “assessment” requirement set forth in Article 19(5). This rule is the equivalent of permitting a retail customer to open an account at an investment firm, such as Fidelity Investments or E-Trade, and manage, within the limitations established by the Directive, his or her own portfolio, without the intervention of the firm’s professional advisor. The benefit to the client should be lower transaction costs.

However, the opt-out provision is subject to severe restrictions that demonstrate the paternalistic approach of MiFID. The Level 2 Implementing Directive specifies that all the following conditions must be met before a client is liberated from a “suitability assessment”:

• The … services relate to shares admitted to trading on a regulated market or in an equivalent third country market, money market instruments, bonds or securitised debt (excluding those bonds or securitised debt that embed a derivative), UCITS and any other non-complex instrument…. The Commission shall publish a list of those markets that are to be considered as equivalent. This list shall be periodically updated,

• The service is provided at the initiative of the client or potential client,
• The client or potential client is has been clearly informed that in the provision of this service the investment firm is not required to assess the suitability of the instrument or service provided or offered and that therefore he does not benefit from the corresponding protection of the relevant conduct of business rules: this warning may be in a standardized format.

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There are several drawbacks to this exception. The first is why limit the investor to such a narrow scope of trading activities. The second is why assume that an investor purchasing a UCITS is not as likely to lose “his shirt” as an investor selling a stock short, a trade presumably prohibited under Art. 21(3) of the Level 2 Directive. The third is the electronic restrictions placed on the account to insure enforcement are likely to annoy the investor and give the appearance that the investment firm is a “financial cop”. The fourth is the expense of the additional recordkeeping the exclusion inevitably would require.

Absent the application of Article 19(6), a firm is obligated to undertake an examination of the client to determine the appropriate level of risk, investment objectives, and nature of advice to be provided. Article 35 of the Level 2 Directive provides that the firm must “obtain from clients or potential clients such information as is necessary for the firm to understand the essential facts about the client and to have a reasonable basis for believing, giving due consideration to the nature and extent of the service provided” that a particular transaction related to portfolio management meets three criteria. These are:

• It meets the investment objectives of the client in question;
• It is such that the client is able financially to bear any related investment risks consistent wit his investment objectives; and
• It is such that the client has the necessary experience and knowledge in order to understand the risks involved in the transaction or in the management of his portfolio.

The Level 2 Directive contains additional requirements to obtain information, provide reporting of trades and portfolio performance, and to provide account statements. These requirements typify expensive investment advice. Read literally, the retail investor must get the permission and advice of the professional money manager before making an adjustment to a portfolio of investments, since there is no explicit provision to opt out of the regime.

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A review of the market indicates that investment funds, both closed and open-ended funds, constitute a primary activity of banks and certain investment firms (The Riga stock Exchange has 8 closed ended funds; see,  http://www.baltic.omxnordicexchange.com/market/?pg=trfunds&lang=en, last visited 30 June 2008. For the Baltic Market, there are an extraordinary array of funds, see http://www.baltic.omxnordicexchange.com/market/?pg=funds, last visited 30 June 2008). For purposes of discussion, Parex Asset Management [PAM], a 100% subsidiary of Parex Banka, and in its words, a “leading investment management company in the Baltics” is used to identify characteristics of fund operation in the Baltic area, in particular from a retail investment viewpoint, though PAM services both retail and institutional clients (A certain irony attaches to the marketing hype of Parex Banka. In November 2008, the bank failed, due to a run on its deposits, and was purchased by a state owned institution for 2 LVL or approximately $USD 4. Now nationalised, the Latvian government must commit massive funds to stabilise the bank and then find a buyer for this institution calling its asset management arm: a “leading investment management company in the Baltics”. The example is drawn from John J.A. Burke, The Baltic Securities Market: Product of Economic Innovation, forthcoming in the Institut Suisse de Droit Comparé (2008)). It also is used to demonstrate the faulty assumptions underlying MiFID investor protection. According to its May 2008 Report, PAM “services more than 200 000 clients, high net worth individuals, corporates [sic], and institutional investors”. PAM has 11 funds registered in Latvia, 5 in Lithuania, 3 in Russia, 3 in Ukraine, 4 in Germany, 3 in Switzerland, and 1 in Sweden. The territorial range of funds is broad but mainly capitalises on the Baltic Sea Region, the Russian Federation, the Republic of Ukraine, real estate in Latvia, and funds of funds. PAM has listed the following fund types on NASDAQ OMX: 5 equity funds, 2 balanced, 3 fixed income [bonds], 5 funds of funds and 1 real estate.

Take the Parex Baltic High Yield Fund. In section 2.2, in the table of fees, a notation at the bottom of the table states, “Total Annual Fund management fee shall not exceed 3.0% of the Fund’s average asset value per year”. The fee to the company is 1.5%, to the custodian 0.15% of the Funds Net Asset Value per year [but then adds EUR 6 per transaction fee], 0.10% to the auditor, and then payment to third parties where fees are not specifically denominated. More disturbing is section 2.3 that is entitled “Other payments from the Fund’s Property”. This section states, “Other payments comprise such expenses as transaction charges, broker fees, and interest on loans”. Taken together, the language of the prospectus is obtuse, and difficult to discern the exact fee an investor ultimately will pay the company. The custodian is Parex bank. Is this MiFID compliant or not? Only litigation would resolve the issue.

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Given PAM the benefit of the doubt, it can be assumed, despite the language in 2.3, that the fees charged per year to the investor are capped at 3%. But the question arises: what exactly does that mean for the investor? In 2006, the fund opened with a NAV in EUR of 1000. As of May 2008, two years later, the fund had an NAV of 1,116.07, an annualised increase of approximately 5%. Given an annual 3% management fee, the investor has paid an average of 30 EUR per year to PAM or 150 000 EUR per year in the aggregate or 300,000 EUR based on the total value of the fund represented at 5 million EUR. Given an average inflation rate of 15%, and not counting the additional expense of brokerage fees to buy and sell securities, the only entity making profit is PAM. The investor is left in the dust. The example aptly illustrates the unsophisticated assumptions of MiFID: that UCITS are safe and non-complex, and the trusting investor is not subject to a fleecing by investing in a presumed safe product.

The nettlesome issues from the viewpoint of the retail investor do not differ in substance from the conditions confronting investors in any developed market, such as the United States. Former SEC Chairman Arthur Levitt has identified the risks for individual investors; Burton G. Malkiel has identified the shortcomings of purported “managed funds” designed to justify high fees (Arthur Levitt, Take on the Street (2002); Burton G. Malkiel, A Random Walk Down Wall Street (ed. 2007). Without disregarding his comprehensive analysis of the fund industry, Levitt focuses first and foremost on the issue of fees. Levitt aptly puts it, “high fees strangle returns”. In 2002, he noted that the US funds industry collected more than 50 billion a year in fees from investors. Levitt states that a fee of 2% is a punishing levy as his illustration tells. An investor placing 10 000 USD in a fund with a 2% management fee and a sales load of 3%, and earning 7.5% over twenty years, would earn $27,508, but have lost $14,970 in fees. He also states that, assuming payment of higher fees is equal to payment of services for “smarter managers” is a myth; it just means the investor is paying more money to the bank or investment company. Applying Levitt’s standards, if a 2% management fee is a punishing levy, then 3% is the equivalent of an investment execution. In addition, the precise fee scheme of PAM cannot be derived from reading the prospectus.

Significantly, PAM is one of the more successful purveyors of mutual funds. SEB’s performance is dismal. Take for example, SEB Choice Asia Small Caps ex. Japan Fund. Launched in 2003, with an NAV less than 2 EUR per unit, the fund’s value as of June 2008 was 2.698 per unit, providing an annualised return of 0.296%. The OMX Baltic Exchange does not provide any information as to prospectus or fees, rendering the web site of limited value (A non-statistically valid review of prospectuses by the author reveals that the prospectus document does not identify the individual companies in which the funds assets are invested). In any event, given broker commissions, and management fees, intuitively it is obvious that the investor has lost any reasonable expected return. That result takes us back to Levitt’s poignant message: what is the investor paying for: money management of little value or of high risk of loss.

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Logic and experience next requires an assessment of payment for professional money management. This is the service being pushed by Baltic banks. However, the evidence is to the contrary. In a “Random Walk Down Wall Street”, Burton Malkiel marshals substantial evidence that payment for a professional money manager is a waste of resources. He makes his case as follows:

“An investor with 10,000 at the start of 1969 who invested in a Standard & Poor’s 500 – Stock Index would have had a portfolio worth $422,000 by 2006, assuming that all dividends were reinvested. A second investor who instead purchased shares in an actively managed fund would have seen his investment grow to $284 000. The difference is dramatic. Through March 31, 2006, the index investor was ahead by $138 000, an amount almost 50% greater than the final stake of the average investor in a managed fund.” (Burton G. Malkiel, supra note 16 at 15-16)

In the context of our Baltic market example, the professional money manager presumably would reply that the return is insubstantial compared to what could be gained with professional money management in the region. However, the cadre of young professionals running the investment funds have not realised until now that they have enjoyed the fruits of a stock market bubble. In fact, the Russian Federation, where many Baltic funds have realised substantial returns, arguably is not necessarily tied to financial acumen, but a market rising on sound economic fundamentals. Nevertheless, as already proved, the average fund on the Baltic Fund Centre list is losing money.

Former Chairman Levitt supports the efficient performance of index funds. He states,

“The Fourth Deadly Sin is also the fund industry’s dirty little secret: most actively managed funds never do as well as their benchmark… For the year ended December 30, 2001, 47 percent of domestic stock funds did not perform as well as the S & P 500, according to Morningstar, even though the S & P lost 13.4 %. And 2001 was one of the better years for managed funds.” (Arthur Levitt, supra at 55)

n spite of financial analysis and technical analysis, unless a trader has inside knowledge, selecting investments is like throwing darts at a board.(Traditional financial analysis cannot even be used in the Baltic Region as it requires companies having at least a 20-year performance history.)

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Burton Malkiel is more caustic: 

“For a twenty-year period, 80% of large cap equity funds failed to outperform the Standard & Poor’s index.” (Malkiel, supra note 18 at 267-68.)  

Since most money managers cannot beat the index, the nature of the regime appears to enrich the investment firm at the expense of the retail client (“A remarkably large body of evidence suggests that professional investment managers are not able to outperform index funds that simply buy and hold the broad stock market portfolio. … For the Twenty years ending December 31, 2005, the average actively managed large-capitalisation mutual fund underperformed the Standard & Poor’s large-cap index by almost 11/2 percentage points per year.” Burton G. Malkiel, A Random Walk Down Wall Street 267-68 (2007). For a twenty-year period, 80% of large cap equity funds failed to outperform the Stand & Poor’s index. Ibid. )

For example, an investor with $10,000 at the start of 1969 who invested in a Standard & Poor’s 500 Index Fund would have had a portfolio worth $422,000 by 2006, assuming that all dividends were reinvested. A second investor who instead purchased shares in the average actively managed fund would have seen his investment grow to $284,000.”(Ibid. at 15.)These results raise the question of whether the investor must be protected from the professional money manager, not the other way around as delineated by the MiFID investor protection policy.

The costs that firms incur to adapt their practices to the Directive will be passed onto the retail investor in the form of commission and fees. Given the probable level of commissions, the portfolio under management would have to perform at an exceptional level for the retail investor to obtain a substantial after-fee and after-tax return on his or her investment. A line from the movie “Wall Street” appears apt: Gordon Gekko asks Bud Fox “Do you know why money managers can’t beat the index. Because they’re sheep and sheep get slaughtered”. MiFID strictures have the capacity of the sheep taking the retail investors with them.