Mifid II Report 2017: Luxembourg

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As the leading investment fund centre in Europe, the products in Luxembourg most affected by Mifid II are undertakings for collective investment (UCI). While not falling directly within the scope of Mifid II, the impact on the distributors of shares/units of UCIs and on the advisors and portfolio managers recommending and/or investing in UCIs, will have a knock-on impact on how UCIs operate and how they are distributed. Partially due to the flexibility of the law of March 22 2004, the markets for bonds and structured finance products are well developed in Luxembourg. Mifid II will affect those markets as trading venues; investment firms trading in such products or offering execution-only services to clients, product manufacturers and bond syndication agents face new obligations under its rules. These new obligations relate inter alia to transparency, product manufacturing and allocation of products to clients.

A draft law has recently come before the Luxembourg parliament to transpose Mifid II (the Draft Law). Pursuant to the provisions of the Draft Law, in its current form there is no gold-plating of the Mifid II provisions. Furthermore, Luxembourg does not intend to exercise national discretion in most of the cases expressly provided for in Mifid II, such as articles 3 (optional exemptions), 16 (organisational requirements), 29 (tied agents) and 70 (powers of competent authorities). In a limited number of instances, the Draft Law concretises a more general obligation under Mifid II. For example, the obligation to require market operators to communicate the list of members of participants to the competent authority "on a regular basis" (article 53(7) Mifid II), is concretised by the obligation to communicate the list to the Luxembourg supervisory authority of the financial sector (the Commission de Surveillance du Secteur Financier – CSSF) on a semi-annual basis.

Since there is no gold-plating and no major exercise of national discretion, we do not have any concerns in this respect.

In our view, the most important extraterritorial issue facing investment firms in Luxembourg stems from the product governance rules set out in article 24(2) Mifid II. Luxembourg-based firms are often manufacturers or distributors. EU firms, in their capacity as product manufacturer or product distributor, must ensure that the products they manufacture or offer are designed to meet the needs of an identified target market of end clients and that the distribution strategy is compatible with that specific market. If the EU firm collaborates with a third country investment firm (not governed by Mifid II) to manufacture and offer the products, the EU firm should put contractual agreements in place to procure that its collaborator's practices meet the standards the EU firm has to comply with. Therefore, the firm's contracting practices with entities acting outside the EU will be impacted by Mifid II in this way. Other important extraterritorial issues are the transaction reporting by non-EU branches of Article 26 Mifir and position limit and reporting regime of articles 57-58 of Mifid II.

The Draft Law transposes the Mifid II rules on (communication of information) and inducements without any divergences, but not the Commission delegated directive 2017/593. Entities in Luxembourg are generally buy-side firms. They do acquire research reports from group entities, which they may make available for their clients or use while providing portfolio management services. The main challenge Mifid II will pose to those entities is how to pay for third party research reports and how to charge clients for those reports.

Pricing research departs from the market practice of sell-side firms to generally offer research bundled with other investment services, such as execution of client orders ('execution-only' services). Pricing research is compatible with the current legal rules which transpose Directive 2004/39/EC.

At present, there is still uncertainty among sell-side firms as to how to separate research from execution-only or other investment services and how much to charge for research reports.

The instruments which will be most impacted by Mifid II in Luxembourg are bonds and structured products. Under the Mifid II regime, all multilateral systems in financial instruments must either operate as multilateral trading facilities (MTFs), organised trading facilities (OTFs) or regulated markets. The OTF regime will subject trading systems involving bonds, structured finance products and derivatives outside of the MTF and regulated market regimes to trade transparency and best execution obligations.

The key challenges with regards to transaction reporting are the implementation of IT infrastructure and procedures to record and transmit transactions in accordance with the Mifir requirements. One challenge with pre-trade transparency will be keeping track of the liquidity status of non-equity instruments. Entities may have to switch from pre-trade transparency to post-trade transparency real-time reporting, if they receive a waiver from the CSSF. Another challenge is setting up the IT infrastructure to meet the pre- and post-trade transparency requirements for different bond market trading structures such as order-book, quote-driven, hybrid and period auction trading systems.

Trading venues have to consider and discharge a number of important obligations. For example, under article 26(5) of Mifir, trading venues have to report details of certain transactions in financial instruments, using legal entity identifiers. Another example is the obligation of a regulated market, which permits direct electronic access to consider whether its members or participants are authorised as investment firms or credit institutions, which involves equivalence issues. Therefore, the main considerations of trading venues and exchanges in setting up rules are (1) how to collect the information necessary to make adequate decisions and (2) which consequences to impose in case of non-compliance.

The heightened investor protection obligations impact the investment fund industry. Distribution of units/shares of investment funds will be impacted further to the rules on inducements and the new rules regarding offering complex products. In addition, manufacturers of fund products in Luxembourg, even if they do not fall within the scope of Mifid II, will have to ensure that distributors of their products have all of the necessary information in order to meet their Mifid II obligations.

The areas of focus of most importance to Luxembourg are the suitability and appropriateness requirements of articles 25(2)-(4) Mifid II, as well as the rules regarding the allocation of instruments and associated delegated regulations. Distributors and portfolio managers must ensure that the financial instruments (units or shares in funds, bonds) are suitable for their clients. For this purpose, the collection and proper analysis of necessary client information will be key. Investment firms that offer services on an execution-only basis, will also focus on the appropriateness assessment and the qualification of offered debt instrument as complex or not (using European Securities and Markets Authority – Esma – Guidelines 2015/1787). Finally, of concern to investment firms involved in bond syndication are the rules on placing, set out in article 38-43 of commission delegated regulation (EU) 2017/565, in particular those on the record keeping and justification of such placements.

In our view, Mifid II offers opportunities for investment firms. For example, the unbundling of investment research from other investment services will stimulate competition in this area and allow investment firms to offer research products to a wider range of buy-side firms. Also, because the required investments and changes to IT infrastructure to comply with reporting, recording and monitoring obligations under Mifid II, investment firms can use the infrastructure to innovate their business processes across the board.

At the same time, Mifid II and Mifir increase the number of regulatory obligations. Investment firms, but also trading venues will have to invest more in regulatory technology and will face more risks of non-compliance. We believe that despite these risks, Mifid II will not substantially impact the competitiveness of the Luxembourg investment fund and securitisation markets.

To prepare themselves, market participants should have several key priorities. First, they should evaluate whether their policies, procedures, governance structures and processes are Mifid II-compliant and identify gaps. Second, they should analyse their business models (including distribution networks and inducements) as well as target client markets, and redefine those models and markets if necessary. Third, they should review and if necessary, draft documentation required by Mifid, such as client disclosures and outsourcing contracts. Fourth, they should put in place information technology infrastructure to comply with the myriad of client assessment, reporting, internal governance, recording and other obligations under Mifid II.

Finally, they should keep abreast of the legal developments in Luxembourg, as the legislator will adopt the Draft Law and transpose Delegated Directive (EU) 2017/593 of the European Commission, in the upcoming months.

About the author
		Evelyn Maher Partner, Bonn Steichen & Partners Luxembourg T: +352 26025 275 E: emaher@bsp.lu W: www.bsp.lu/professionals/partner/evelyn-maher Evelyn Maher has been active in the Luxembourg investment fund market since 2001. She assists fund promoters and asset managers in relation to the structuring and establishment of a wide range of funds including private equity, venture capital, loan origination, loan participation and real estate. She provides advice on compliance with all aspects of the regulatory regime applicable to investment funds and in particular, the alternative investment fund managers directive (AIFMD). Following the launch of a fund Maher offers ongoing assistance in relation to closings, investments, divestments, liquidation and general issues arising throughout the life of the fund. She has also provided assistance in relation to the listing of securities on both the regulated and Euro MTF markets operated by the Luxembourg Stock Exchange. Maher advises clients regularly in relation to the regulatory regime applicable to listed issuers i.e. advice on takeover, corporate, market abuse and transparency regulations. She has extensive experience in relation to Luxembourg regulatory and corporate law.

About the author
		Melvin Tjon Akon Associate, Bonn Steichen & Partners Luxembourg T: +352 26025 268 E: mtjonakon@bsp.lu W: www.bsp.lu/professionals/associate/melvin-tjon-akon Melvin Tjon Akon joined BSP in 2015 and is admitted to practice in the State of New York. He is mainly involved in financing transactions (including syndicated loans and investment fund financing) and capital markets transactions. His practice also includes advising on financial regulatory matters, with a particular focus on investment firms, banks and fintech companies. In addition, he assists clients with corporate and financial restructuring transactions, as well as corporate acquisitions.