On 24 May 2023, the European Commission published the current status of the Retail Investment Strategy and set the feedback process on the now published legal texts until 31 July 2023. It is clear from the drafts of the EU Retail Investment Strategy that commission payments (so-called induce-ments) are not to be comprehensively banned after all.
The EU Retail Investment Strategy
The EU Retail Investment Strategy is part of the Capital Markets Union (CMU) adopted in 2020. As part of this overall strategy, the European Union has adopted a series of legal acts to subject the various financial markets to uniform regulation and to further reduce restrictions on the cross-border flow of capital within the Union.
Union citizens invest significantly less money in financial products than is common in other industrialised countries. In order to increase the willingness of retail investors to invest in the capital market, the Union is planning the Retail Investment Strategy package of measures. This is intended to amend and thus standardise various regulations applicable to retail investors. The package of measures is intended to ensure the necessary confidence of retail investors in order to normalise supplementary private pension provision on the capital market on the one hand and to support investments in the European economy on the other.
If investors seek advice before an investment, it has been customary up to now that the advisor is remunerated for his services (commission) as soon as an investment decision is made as a result of his activities. From the point of view of the responsible EU Commissioner, Mairead McGuinness, this creates two major problems: Firstly, that investment advisors can be misled into recommending products that trigger a higher commission, although another product would better meet the needs of the retail investor. On the other hand, a presumably significant increase in the price of the brokered products. Although the commission is transferred to the investment advisor by the issuer of the financial product, it also makes the brokered product more expensive, as it is priced into it. Originally, the Commission therefore planned an EU-wide, complete ban on commissions in order to completely eliminate these problems.
The proposal caused fierce opposition from the professional sector. In fact, there are also weighty arguments in favour of performance-based commissions. We have already presented these. In its recently presented draft, the Commission now refrains from this comprehensive commission ban in its original form – and justifies this with considerable and sudden effects on the existing distribution systems. Instead, it is planning further regulations in addition to a weakened commission ban in order to achieve a high level of protection for retail investors.
What is a commission ban?
A commission ban is the prohibition of the acceptance or payment of fees or other benefits from or to third parties in connection with the performance of a (here: investment) service.
Already today, there is a prohibition of commissions in the provision of investment services. MiFID II contains requirements under which conditions inducements from third parties may be accepted. Third-party inducements are prohibited if the investment firm provides independent fee-based investment advice or portfolio management. These restrictions are to be maintained and supplemented.
In addition, there is a restricted prohibition of inducements for other investment services. If an inducement is accepted from a third party in connection with such an investment service, it must be intended to enhance the quality of the respective service for the client and must not interfere with the duty of the investment firm to act in the best interest of the clients. This restriction is to be removed and replaced by new regulations.
What is now planned instead?
In order to allow existing distribution systems to be adapted and to minimise the costs of such a change, the Commission limits the planned commission ban in its current draft to certain individual cases:
Prohibition of commission for pure execution transactions
Investment firms are not allowed to charge commission if they merely carry out a transaction on behalf of the retail investor (investment brokerage) without having previously advised the retail investor on the product (execution only). This is the case – as in particular in the business model of neobrokers – if the retail investor does not base his investment decision on prior advice given by the investment firm. Advice is given if the investment firm makes a personal recommendation to the retail investor based on an individual assessment of the investor’s circumstances.
However, the commission ban shall not apply to such commissions which the investment firm receives from such issuers for which it provides the issuing or placement business. However, this shall not apply to issuers of “packaged retail and insurance-based investment products” within the meaning of the PRIIPs Regulation – for these again the commission ban applies.
Abolition of the previous restricted ban on commissions
The previous restricted prohibition of commission, which only allowed the acceptance of inducements if this led to an improvement in quality and did not impair acting in the best interest of the clients, was primarily aimed at avoiding conflicts of interest. The Commission has found this regulation to be insufficiently effective in this regard. The regulation is therefore to be repealed and replaced by a new standard in the form of a general obligation for investment firms: In order for investment firms to act in the best interest of the client when providing investment advice to retail clients, the investment firm shall
- provide advice based on an assessment of an appropriate range of financial instruments;
- recommend the most cost-effective financial instruments among those identified as suitable for the client and having similar characteristics;
- recommend from the range of financial instruments identified as suitable for the client one or more products that do not have additional features that are not necessary for the achievement of the client’s investment objectives and incur additional costs.
Receipt of analyses
Furthermore, the Directive provides that third party analyses shall continue to be conducted with the requirement to act honestly, fairly, professionally and in the best interests of the client if:
- Prior to the provision of execution or research services, there is an agreement between the investment firm and the research service provider specifying the fees and payments for the services
- The investment firm informs retail investors what payments are made for execution and analysis services.
- The payments made only include analysis services whose subject matter are companies whose market capitalisation does not exceed 10 billion euros.
The regulation also includes how the maximum market capitalisation of analysed companies is to be calculated and which documents and services are covered. The adjustments to the current legal situation are minor in this respect.
What is not affected by the commission ban?
However, the restrictions on the prohibition of commissions now provided for do not cover all investment services.
Commissions on investment advice
If an investment firm makes an investment recommendation based on the personal needs of the client, it should be allowed to receive performance-related commissions in the future.
However, investment firms entitled to receive commissions must ensure that they provide their services in an honest, fair and professional manner in order to comply with the duty to act in the best interests of their clients. In addition, investment firms will continue to have a duty to disclose the nature and amount of third party payments to the retail client. However, this does not apply to payments or benefits that are necessary for the provision of the investment service (this means custody costs, settlement and exchange fees, regulatory levies or legal fees) and which, by their nature, are not likely to jeopardise the fulfilment of the obligations just mentioned.
De minimis exception for minor non-monetary benefits
The proposed directive would also allow investment firms offering portfolio management or executing execution transactions to receive “minor” non-monetary benefits. However, these must not embody a total value greater than €100 per year or be of such a nature and extent that they cannot be considered to interfere with the investment firm’s compliance with its duty to act in the best interests of the client. The receipt of any such benefit shall be disclosed by the investment firm to clients.
Reservation of the right of the Commission to amend
The Commission reserves the right to introduce the originally planned commission ban after a three-year observation period, should it become apparent that the mechanisms introduced instead prove to be insufficient for investor protection or are only insufficiently implemented by investment firms. To this end, it shall assess, in consultation with the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA), whether the availability of independent advice is jeopardised by the provisions introduced, with a view to potential conflicts of interest.
What effects can be expected? An outlook
The changes to the original directive proposal that have now been implemented – due to pressure from the financial industry – are an improvement compared to the complete ban on commissions, but lead to particular challenges for the distribution structures of fintechs and neobrokers. In order for these to continue to finance themselves, the introduction or increase of fees for investors becomes likely, as these can now no longer be borne by the issuer. German retail investors in particular often shy away from the higher cost of advice. In addition, it will be difficult for retail investors to understand why the advisory business can be offered more cheaply – or possibly free of charge – (since it may be financed by inducements), but the non-advisory business costs (due to the commission ban). From the point of view of retail investors, this results in a higher direct price for less service. The willingness of investors to invest is likely to decline with higher mark-ups for commissions. The fact that this strengthens investment advice (including AI-based investment advice, so-called robo advice) is not a compelling consequence. Thus, the proposal, which is actually an intermediary, threatens to make free access to the capital market more difficult and thus to reverse its effect.
Industry representatives have already announced their opposition to the planned obligations from the directive. It therefore remains to be seen which provisions will find their way into the retail investor strategy at the end of the legislative process. It promises to be an exciting legislative process.
With the kind support of Manuel Traub, research assistant.
