Killick & Co – Written Evidence (FRS0005)
Summary: Killik & Co, an award-winning retail investment company and independent Partnership, is a significant player in the UK wealth management market, managing assets on behalf of some 20,000 clients.
Despite the laudable objectives of MiFID II, the reality is that some aspects of the regulation are ill-conceived and will be both damaging and harmful to retail investors. This submission highlights four, namely: Product Governance, the 10% down disclosure rule, Providing a Suitability Report to an Advised Client before or whether or not a transaction is approved and executed and Inducements/Unbundling.
Product Governance: The term ‘product’ has never been applied to an individual security, be it a bond or an equity. It appears through the final guidance offered by European Securities & Markets Authority that MiFID ll seeks to change that. As a result, an issuing house, which is generally a bank, bringing an equity or bond issue to the market is a “product manufacturer” for the purposes of the Product Governance regime. As such they have both initial and ongoing responsibility and with it potential liability for the “product”. If not resisted, it is very likely that banks will simply walk away from the potential responsibility and liability by ensuring that any IPO or rights issue is only placed into the hands of a professional investor. This may entail new issues including rights issues being confined to a Specialist Equity Segment of the London Stock Exchange, thereby denying retail investors access to all issues after 3 January next year or being able to trade them in the secondary markets forever after.
The 10% down disclosure rule: It is proposed that investment firms providing the service of portfolio management shall inform the client where the overall value of the portfolio, as evaluated at the beginning of each reporting period, depreciates by 10% and thereafter at multiples of 10%, no later than the end of the business day in which the threshold is exceeded or, in a case where the threshold is exceeded on a non-business day, the close of the next business day.
By way of a chart covering the worst period of the last financial crisis in 2007/08, we illustrate the absurdity of this rule and express our concern that if a similar scenario were to arise, the impact could be wider spread panic selling leading to a deeper and longer lasting recession. This would be detrimental not just to a few investors but to the economy of the UK and potentially that of the EU as a whole.
Providing a Suitability Report to an Advised Client before or whether or not a transaction is approved and executed: This rule is simply impractical in the UK. It reflects the fact that much of European regulation is drafted with a product focus reflecting the way in which investments are typically accessed by Continental European customers. Reading them across to the UK wealth management sector is always a challenge as it fails to recognise the benefits of direct ownership in securities over 'packaged' product access and the resulting differences in advisory processes in the UK. The time and cost implications of having to produce suitability reports whenever advice is given, even where there is no resulting transaction, threatens the future of advice services to retail clients. One of the key aims of the UK's Financial Advice Market Review (FAMR), commissioned by the Treasury in partnership with the Financial Conduct Authority (FCA), was to find ways to make financial advice more affordable and accessible. The requirement for a written suitability report for all advice, whilst logical from an EU single product sale perspective, directly challenges the aim of FAMR.
Inducements/Unbundling: MiFID II requires that investment houses must separate (unbundle) the cost of their investment research from the cost of execution: research that had ostensibly been made available for free will now have to be paid for. These increased costs will ultimately be borne by clients, or firms will stop/reduce the amount of research they access and as a result will be less well informed when giving advice or making discretionary investment decisions. Either way, a set of rules that were intended to enhance transparency and fairness for consumers could actually be detrimental in terms of quality of advice/management and cost.
1.0 Introduction: Killik & Co is an award-winning retail investment company and independent Partnership, providing advice on savings, planning and investment to retail investors through a network of branches. It is a significant player in the UK wealth management market, managing assets on behalf of some 20,000 clients.
1.1 MiFID II: Not all the measures in the EU’s revised MiFID and MiFID 11 are negative – indeed attempts to bring about simpler and more transparent pricing are to be applauded. However, despite these laudable objectives, the reality is that some aspects of the regulation are ill-conceived and will be both damaging and harmful to retail investors. This submission highlights four, namely:
- Product Governance. European Securities & Markets Authority (ESMA) MiFID ll Final Report Guidelines on Product Governance Requirements
- The 10% down disclosure rule. Article 62 (1) Delegated Regulation of 25.4.2016
- Providing a Suitability Report to an Advised Client before or whether or not a transaction is approved and executed. Article 25 (6) Directive 2014/65/EU and ESMA Q&As
- Inducements/Unbundling. Article 13 (1) (a) and (b) Delegated Directive of 7.4.2016
2.0 Product Governance. European Securities & Markets Authority (ESMA) MiFID ll Final Report Guidelines on Product Governance Requirements
2.1 In financial services, the term ‘product’ is commonly used to define a collective investment scheme in various, different formats. It has never been applied to an individual security, be it a bond or an equity. It appears through the final guidance offered by European Securities & Markets Authority (ESMA) that MiFID ll seeks to change that. (ESMA MiFID II Final Report Guidelines on Product Governance Requirements).
2.2 It is now being suggested that an issuing house, which is generally a bank, bringing an equity or bond issue to the market is a “product manufacturer” for the purposes of the Product Governance regime. As such they have both initial and ongoing responsibility and with it potential liability for the “product”.
2.3 The banks already struggle with their “initial” responsibilities, through IPOs and rights issues, and the potential liabilities that might arise, hence the current weight of a prospectus.
2.4 However, they cannot possibly know what the “ongoing” liabilities are that might arise from issuing securities into the retail market.
2.5 Bizarrely the issuing bank, seen as the product manufacturer, will be required to monitor the “product” on an ongoing basis to ensure that it functions as expected; that it is sold to the expected target market; and that it remains consistent with the needs of the target market.
2.6 This concept might work in relation to a collective investment product, where the product manufacturer can ensure that it is managed in accordance with a mandate. However, it cannot work in the context of the shares and bonds of companies, where the role of the issuing bank concludes after the issue has taken place or shortly thereafter.
2.7 As a consequence, it is very likely that banks will simply walk away from the potential responsibility and liability by ensuring that any IPO or rights issue is only placed into the hands of a professional investor, thereby denying retail investors access to all issues after 3 January next year or being able to trade them in the secondary markets forever after.
2.8 There is a vague reference to “mass-market shares” in the context of a “blue chip equity” in the ESMA guidance, but there is no explanation of what is meant by these expressions.
2.9 We understand that the banks would have no objection to retail access to issues, if it were not for additional regulatory burdens. They don’t want to have to write prospectuses in retail-speak. They don’t want to have to boil prospectus disclosure down into a summary, for which they may have liability. They don’t want to undertake full product governance responsibilities for the life of the issue.
2.10 All of these are examples of well-intentioned attempts at consumer protection that don’t work and simply drive issuers and their advisers away from retail investors. Unless the lawyers can find a work around, which appears unlikely, the liability attaching to all new issues after 3rd January will, over time, increasingly deny retail investors direct access to equity and bond markets
2.11 We have an aging society that needs to be encouraged to save, but a regulator that is so keen to protect them that it won’t allow them direct access to the tools that they need. Instead the rules seem bent on increasing the unhealthy trend away from listed markets towards private equity and an even more highly leveraged corporate sector.
2.12 In short, we strongly believe that the whole concept of a share or bond being a “Product” and falling under “Product Governance” must be resisted. This argument was accepted when drafting the Packaged Retail and Insurance-based Investment Products Regulation, which had originally sought to include shares and bonds within its scope.
3.0 The 10% down disclosure rule. Article 62 (1) Delegated Regulation of 25.4.2016
3.1 Investment firms providing the service of portfolio management shall inform the client where the overall value of the portfolio, as evaluated at the beginning of each reporting period, depreciates by 10% and thereafter at multiples of 10%, no later than the end of the business day in which the threshold is exceeded or, in a case where the threshold is exceeded on a non-business day, the close of the next business day.
3.2 The chart below, covering the bear market, over the worst period of the last financial crisis, provides an example of the absurdity of this rule. It demonstrates what would have taken place between the receipt of a periodic quarterly statement on 31 December 2007 when this hypothetical portfolio was worth £100,000 and two years later. The value of the portfolio had already fallen from a peak of £104,240 on 12h October 2007 and bottomed on 3 March 2009 when it was worth £54,393. It thereafter recovered to a value of £83,831 on the occasion of a periodic regular quarterly statement on 31 December 2009.
3.3 The regular quarterly statements in the chart are shown in green (referred to as quarterly letters), the subsequent notifications of a 10% fall from the previously notified level is shown in red (referred to as letters). In the space of just over 14 months from 31 December 2007 to 3 March 2009, a client would have received 5 periodic quarterly statements showing declining values, plus 4 interim notifications showing 10% falls from previously notified levels.
3.4 It is seldom recognised that the most important role provided by an Investment Manager looking after client assets is Behavioural Coaching, trying to ensure that they don’t follow the herd, thinking that the herd knows where it is going. That applies to either panicking out of a falling market or feeling the need to throw money at the final stages of a rapidly rising bull market.
3.5 The author has personally advised Private Clients on their investments for approaching 50 years and therefore has some knowledge of how they think. Investors know when we are in a severe bear market as it is being reported to them daily by the media. The vast majority do not have masochistic tendencies and, recognising the quarterly periodic statements (shown by the green bars above) when they arrive, most don’t even bother to open them. However, we are now being forced to add to their pain by providing additional notifications (shown by the red bars above) telling them that the picture looks even worse. We will obviously speak to clients, tell them to put their “tin hat” on and not to panic, and their response is likely to be “if you want me to stop panicking, then stop sending me these reports telling that things are even worse than I thought they were”. To which we will have to respond “sorry, we can’t stop sending them, it’s the rules”.
3.6 At what point between September 2008 and March 2009 will the investor say, “enough is enough, just get me out of here whilst I have some value left”. Will it be when the value is £77,833 on receipt of the notification of 16 September 2008 or when they receive either of the two further notifications piling on the pain until by 3 March 2009 the value is down to £54,393?
3.7 One thing can be certain - a very large number of private investors would have panicked out. To make matters worse, sadly they would not have re-entered the market during the journey back to £83,831 at the end of December 2009. They would be too nervous of compounding their error by getting back in before a further fall. Had this happened they would, almost certainly still be in cash today, having lost confidence in the stock market with the refrain “it’s just a bloody casino”.
3.9 Having provided an historic example, we are concerned that in a scenario like that of 2007/08, which in terms of market cycles we could be due again very soon, the impact could be wider spread panic selling leading to a deeper and longer lasting recession. This would be detrimental to the UK economy, not just a few investors. If the same investor behaviour is triggered across the EU as a result of these warning notifications then who knows what impact that could have on the global economy.
3.10 Whilst the UK regulator has been considering behavioural economics quite carefully recently, we are unclear if this has been taken into account at a European level when drafting MiFID ll. One suspects not as it is relatively new thinking that probably had little prominence when the legislation was being drafted nearly ten years ago. What a wasted effort it will have been if the changes to market regulation conceived in the aftermath of the 2008 crisis to make them more resilient and improve investor protection in fact had the opposite effect.
4.0 Providing a Suitability Report to an Advised Client before or whether or not a transaction is approved and executed. Article 25 (6) Article 25 (6) Directive 2014/65/EU and ESMA Q&As
4.1 According to the second subparagraph of Article 25(6) of MiFID II, the firm shall, when providing investment advice, before the transaction is made, provide the client with a statement on suitability in a durable medium specifying the advice given and how that advice meets the preferences, objectives and other characteristics of the retail client.
4.2 Article 54(12) of the MiFID II Delegated Regulation states that firms shall provide a suitability report when providing investment advice. The report shall, inter alia, include an outline of the advice given and how the recommendation is suitable for the retail client. By outlining that the report shall be given when providing investment advice, the implementing measures clarify that the suitability report has to be provided to the client irrespective of whether or not the advice is followed by a transaction. In fact, investment advice, as defined in Article 4(2)(4) of MiFID II does not require a recommendation to be followed by a transaction.
This text is taken from the ESMA Q&A dated December 2016.
4.4 An Advisory client will expect to have a free ranging conversation with their Broker covering markets in general as well as investment ideas coming from the client and investment ideas from the Broker and will expect to be able to trade on the back of such a conversation and at the prices quoted at the time or subject to limits conceived at the time and in the context of the conversation.
4.5 To expect what might be a lengthy conversation, to be summarised in a Suitability Report whether before or after any transactions are undertaken and whether or not any transactions are instructed will potentially kill the Advisory market, an important pillar of Retail Stockbroking, which is greatly valued by many hundreds of thousands of retail investors.
4.7 One of the key aims of the UK's Financial Advice Market Review (FAMR), commissioned by the Treasury in partnership with the Financial Conduct Authority (FCA), was to find ways to make financial advice more affordable and accessible. The requirement for a written suitability report for all advice, whilst logical from an EU single product sale perspective, directly challenges the aim of FAMR.
4.8 We wish to remain committed to the advice market and are actively trying to develop technology that we hope will enable us to continue to offer low cost, yet high standards of advice in the future in line with FAMR's ambitions. However, regulation increasingly makes advice more difficult and more costly to deliver.
4.9 Whilst the MiFID II text itself cannot be amended at this late stage, there are certain interpretations being made by ESMA that are making a bad situation worse, such as the one quoted above, where they have determined that a suitability report is required even where there is no resulting transaction. There would seem to be little additional investor protection from a report that recommends no action, yet it will likely increase the cost of giving advice. In an effort to soften the potential damage of this rule, we would argue that the MiFID II rules should be read in a way that means only where a transaction is agreed is a suitability report required. In the meantime, the FCA must make clear how a regulated firm can provide stockbroking advice to a retail investor in conformity with these rules. They might make some sense in the context of the purchase and sale of packaged investment products, but not for single stock advice. A portfolio is, or is not, suitable by dint of its overall composition, not by each individual underlying investment. Also, the FCA should seek to explain what problem it believes that suitability reports would solve. Its own review into the suitability of advice in the financial advisory sector, carried out last year and published on 18 May, found that in over 93 per cent of cases, suitable advice had been given.
4.10 Therefore, it would seem that suitability reports are seeking to be the answer to a problem that doesn’t exist. On the publication of the review, the FCA wrote: “The purpose of the review is to assess a statistically robust sample of advice files that allows us to draw conclusions on the suitability of advice and quality of disclosure in the sector as a whole”. We would suggest that two conclusions to be drawn are that written suitability reports are not needed and are unjustified by the FCA’s own evidence.
4.11 Advisory stockbroking is a service that many fewer firms are now offering, for both regulatory as well as commercial reasons, notwithstanding the considerable demand that still exists. This proposed rule change could prove to be the final nail in the coffin of this service, leaving investors with a choice only between Execution Only and Discretionary Management.
5.0 Inducements/Unbundling. Article 13 (1) (a) and (b) Delegated Directive of 7.4.2016
5.1 MiFID II requires that investment houses must separate (unbundle) the cost of their investment research from the cost of execution. This means that research that had ostensibly been made available for free will now have to be paid for. Again, the rules have good intentions, and some logic when applied to the Institutional Market. However, under the new rules they will apply even where a firm that receives research for free does not execute any transaction with the investment house, i.e. where there is no inducement. This commonly applies to retail firms who are diligent in providing “best execution” and will deal at the best price irrespective of any research received. Sell side houses have always made their research available to firms advising retail investors in the interest of better informing the market.
5.3 We would urge the FCA and ESMA in their guidance to consider the time value of research in a retail context. Research is most valuable upon publication, but that value rapidly diminishes over time. Under proposed rules a retail broker would be in breach of the rule were they to read a research report that they had not purchased months or even years after its publication. This is thoroughly impractical and impractical regulation is in nobody’s best interest as it only serves to make such regulation look ill-considered. However, most retail firms would be content to receive a research report a week after publication which has not been purchased without being in breach.
5.4 To conclude we would also like to draw attention to the ESMA Securities and Markets Stakeholders Group, and their SMSG End of Term Report of June 2016:
5.5 It is interesting to note the recommendations given on page 29: Closely linked to this issue, the SMSG notes the risk of a shrinkage of the availability of advice for retail investors. The experience in the UK gained through the Retail Distribution Review (RDR), although still at an early stage and evolving advises cautions (sic.). It appears particularly that middle income savers now have great difficulty in finding decent advice on their savings needs, even as their need for guidance increases the more this could lead to a two-tier system where an increasing proportion of advice is focused on higher income target groups.
5.6 On the same issue of avoiding unintended adverse consequences, the SMSG considers a major issue that ESMA labels investment research as an inducement as this will lead to a de facto ban. This could have adverse severe consequences on research on SMEs which MiFID II aims at the same time rightfully to support. We strongly advise ESMA to reconsider their stance by deleting the paragraph relating to investment research.
These powerful statements from their own Stakeholder advisory group appear to have been ignored.
29 September 2017