To complement the recognition of fiduciary duties, MiFID introduced a regime of client and product classification through which it assigns different levels of protection to clients. According to MiFID, the level of protection offered by CoB requirements should be related to the clients’ classification. The Directive, therefore, defines two main categories of clients:
i) Retail (Art. 4.1 (12)); and
ii) Professional (annex II, Sec. 1, MiFID).
Client classification
All investors that are not classified as ‘professional’ fall under the ‘retail’ category (definition by exclusion) and enjoy the highest level of protection afforded by MiFID, typically through the application of all ORs and CoB rules. However, they may ask to be treated as ‘professional’, if they pass two tests: a basic test (which assesses the expertise, experience and knowledge of the client); and a specific test (which requires the investor to meet two out of three ‘wealth-related’ thresholds, as defined by Annex II, Section 1, MiFID).
Retail
Professional investors are those who have the expertise and are able to make their own investment decisions. To them, a ‘softer’ regime applies that takes into account their more sophisticated nature, e.g.: they only receive client information on request. MiFID ‘rules’ are the same overall for both retail and professional investors, but are tailored to the nature and needs of each group of investors. Professional investors are, amongst those listed in Annex II, Section 1.1 MiFID, investment firms, credit institutions or insurance companies. They can ask to be treated as retail clients but the other party has to agree. They may also request to become an eligible counterparty.
Professional
The Directive, in effect, introduced a third ‘special’ category, called ‘eligible counterparties’ (ECP; Art. 24).208 This group of entities includes the most sophisticated clients, such as investment funds – either alternative investment funds (AIFs) or UCITS. Only few CoB rules and ORs apply to them, such as client agreement rules (Art. 18) and order handling rules (if acting as broker; Art. 19.8). Professional investors may request to be treated as ECPs if their member state has decided to implement this possibility. These investors need to meet a different test from the one adopted for retail investors to be considered professional. Professional investors must meet two out of these three criteria (Annex II, Section 1.2):
1) A balance sheet of more than €20 million;
ECPs
208 ECPs are “investment firms, credit institutions, insurance companies, UCITS and their management companies, pension funds and their management companies, other financial institutions authorised or regulated under Community legislation or the national law of a member state, undertakings exempted from the application of this Directive under Article 2.1(k) and (l), national governments and their corresponding offices including public bodies that deal with public debt, central banks and supranational organisations.”, Art. 24, MiFID.
2) A net turnover of more than €40 million; and 3) Own funds of more than €2 million.
The ‘light touch’ regime applies to ECPs when they offer services such as execution of orders; dealing on own account; reception and transmission of orders; or any related ancillary service.
Client classification should be defined before providing the service and should be included in the contract or anyway stated in writing. Retail investors cannot be classified as ‘ECPs’, while financial institutions (including ECPs) can be classified on request as ‘non-professional’ (retail; Art. 24.2, MiFID). All other combined classifications are possible. For instance, the management company of an investment fund may ask a dealer, executing an order on its behalf, to provide best execution following ‘retail’ instead of the ‘professional’ standards, since the fund mainly collects investments from retail investors. The firm/dealer also needs to agree to this request and if it so does, it would have to apply the relevant retail or professional tests when offering services to such eligible counterparties. Some segments of the market suggest that portfolio managers should be entitled to require reclassification as ‘retail’ clients, since there is a mismatch in their rights and obligations. Portfolio managers are eligible counterparties under MiFID but they manage money on behalf of professional and retail clients, and they have the obligation to act in the best interest of their clients when placing orders for execution. Others, however, consider this request to be inappropriate because it may also be used for activities unrelated to retail clients, and most notably because this would no longer justify that portfolio managers gain directly (through commission on profits) from rules that should go directly to serving retail clients. In effect, their role goes beyond the execution on behalf of investors.
It is a commonly held view that the client categorisation regime should not be radically changed (CESR, 2010c; EU COM, 2010b). Current proposals, however, concern (EU COM, 2010b): the possibility to extend the general clause of Art. 19.1 to ECPs; the limitation of the ECP regime only to non- complex products and the exclusion of non-financial institutions from the ECP regime; the abolishment of the presumption that professional investors have the necessary expertise and knowledge; and the exclusion of municipalities209 from being classified as ECP or professional per se. In particular, abolishing the presumption of expertise and knowledge for professional investors would require investment firms to treat them as retail clients. This situation, on the one hand, increases the general level of protection in the market, but it boosts overall costs of dealing with clients, on the other. To reduce the imbalance of this trade-off towards costs, an opportunity to opt out of the protection for retail clients should be left available to be unilaterally exercised at any time for those who consider themselves to be ‘professional’ investors. However, there is also a bias that comes into play. A homogeneous application of retail investors’ protection rules may need the implementation of sophisticated and burdensome protection tests, which may be perceived as high sunk costs for investors to comply with standard procedures (such as complex and long questionnaires).
New proposals
They may ultimately decide to opt out to avoid those time-consuming obligations. Abolishing such distinctions may therefore generate unclear effects on the provision of investment services.
Conclusion # 19
Although the crisis showed that some of the eligible counterparties (ECPs) were not able to understand risk ‘properly’, the client categorisation regime should not be subject to a major overhaul. Since portfolio managers are eligible counterparties under MiFID but manage money on behalf of professional and retail clients and have the obligation to act in the best interest, some market participants suggest that portfolio managers should be entitled to unilaterally require the reclassification as ‘retail’ clients. Others, however, advocate the inappropriateness of this request since their role is more than execution on behalf of investors, but they would directly gain (commissions on profits) from rules that should theoretically only benefit retail investors.