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Topic Consumer protection Inducements - Ban with an exception: tighter rules for commissions and other benefits

Date: 24.09.2018

Triangular relationships can be complicated. As in everyday life, this also applies to the provision of investment and ancillary services and to the triangular relationship between a client, an investment services enterprise and a third party: an investment services enterprise provides an (ancillary) investment service to its client.

It becomes complicated if another person – for example the issuer of the security – joins this bilateral relationship, and the third party grants an advantage to the investment services enterprise in connection with the provision of the (ancillary) investment service to the client.

Definition:Investment and ancillary services

Section 2 (8) and (9) of the German Securities Trading Act (WertpapierhandelsgesetzWpHG - only available in German) contains an exhaustive list and definition of investment and ancillary services. Examples of key investment services that consumers often come into contact with are investment advice and portfolio management. The safe custody business, which involves the safe-keeping and administration of financial instruments, is an important ancillary service for many consumers. As a rule, a securities account is a condition for being able to hold securities such as shares.

Conflicts of interest

Granting and accepting the benefits that lawyers refer to as “inducements” can trigger conflicts of interest. These can arise when an investment services enterprise, for example a bank, receives an inducement from a third party that could influence the enterprise when it provides (ancillary) investment services to the client.

Take the following example from the area of investment advice: if a bank receives a commission from an issuer for the sale of certain securities, this commission and the amount of the commission may pose an incentive for the bank to allow itself to be swayed when providing investment advice to the client. The client’s interest could thus be subordinated to the bank’s interest in selling the security.

Definition:Inducements

Under section 70 (2) sentence 1 of the German Securities Trading Act (WertpapierhandelsgesetzWpHG - only available in German), inducements are commissions, fees and other cash payments as well as all non-cash benefits. The definition is therefore very broad. It is important to know that inducements can be provided not only in the form of cash payments (monetary inducements), but also in the form of other benefits (non-monetary inducements). Examples include providing services, IT hardware or software, and training. See the “Examples of common types of inducements” info box for information about common types of inducements.

Inducements regime

The rulebook for the inducements regime is intended to ensure that clients nevertheless receive investment advice in accordance with their best interests.

The previous rulebook, which goes back to the first Financial Markets Directive (MiFID I), was tightened on 3 January 2018 by MiFID II and a Delegated Regulation based on MiFID II, as well as the corresponding German implementing act (Second Act Amending Financial Markets Regulations (Zweites Finanzmarktnovellierungsgesetz – 2. FiMaNoG), see BaFin Journal June 2017 - only available in German) and the new Regulation Specifying Rules of Conduct and Organisational Requirements for Investment Services Enterprises (Wertpapierdienstleistungs-Verhaltens- und Organisationsverordnung – WpDVerOV).

Commission-based investment advice

Germany continues to be dominated by commission-based investment advice. In this model, the investment services enterprise offering investment advice is remunerated, at least in part, by the providers or issuers of the financial instruments. Clients who visit an adviser, for example at the local branch of their bank, may get the impression that the advice they receive doesn’t cost anything. However, the inducement is ultimately priced in.

At a glance:Examples of common types of inducements

  • Kick-backs/retrocessions generally describe a case where a third party – for example the issuer – forwards payments from the client to an investment services enterprise – for example the fund broker.
  • Sales commissions are paid directly by a third party for the sale and the distribution of financial instruments, such as front-end loads for investment funds and placing commissions for certificates.
  • Trail commissions describe the – in most cases annual – payments that a fund broker receives out of the investment fund’s management fee for as long as clients hold the investment fund in their custodian account.
  • Sliding scale commissions are variable inducements, generally payed at progressive rates or levels, which depend on certain levels of sales, revenues or deposits being reached.
  • Transaction commissions (payments for order flow) are granted for forwarding client orders to certain counterparties or execution or trading venues.
  • Finder’s fees are paid by some investment services enterprises for the acquisition of new clients.
  • Equity brokerage commissions are paid for raising new equity when investments in partnerships such as alternative investment funds and investment products are brokered, often in addition to sales commissions.

There is a general ban on inducements in the rulebook for the inducements regime: investment services enterprises may not accept inducements in connection with (ancillary) investment services from third parties who are not the client for those services.

However, there are exceptions to this ban that are subject to certain strict conditions. They are the legal basis for allowing commission-based investment advice to be provided at all, and can be summed up in two key terms: transparency and quality enhancement.

Transparency: disclosing the inducement

In the first instance, the investment services enterprise must disclose to the client any inducements it receives from another party in connection with a service. It must also state the nature and amount of the benefit in advance, i.e. before it provides the (ancillary) investment service.

If the amount of the inducement cannot be determined at this time, for example because it depends on an outstanding factor – e.g. in the case of sliding scale commissions – as a minimum the way it is calculated must be disclosed. The customer must also be subsequently notified of the exact amount of the inducement.

The inducements must also be disclosed as part of the service costs in the information on costs and associated charges (see BaFinJournal July 2018 - only available in German).

Quality enhancement: surplus value for the client

So that the ban on inducements does not apply, the inducement must also be designed to enhance the quality of the relevant service provided to the client.

The quality of investment advisory services, for example, can be enhanced if the client is advised based on a wide range of suitable financial instruments from third party providers having no close links with the investment services enterprise. The client also benefits if the bank assesses at least once a year the continuing suitability of all financial instruments the client has bought on the bank’s recommendation. Advice about suggested optimal asset allocation of the client above and beyond recommending an individual financial instrument can also be viewed as a quality enhancement. However, the adviser should also consider the client’s individual attitude to risk, investment purposes and investment term required in order to generate appropriate surplus value for the client. Finally, enhancing the quality of investment advice can also mean giving clients better access to advisory services.

Investment advice on an independent basis

The rules on disclosure and quality enhancement apply to all (ancillary) investment services – with two exceptions: investment advice on an independent basis and portfolio management. There are more restrictive rulebooks for these services.

Clients have the option to use fee-based investment advice on an independent basis instead of commission-based advice. However, only a small number of investment services enterprises currently offer this service. An overview of the enterprises offering investors fee-based investment advice on an independent basis is provided by the register of fee-based investment advisers , which is available on BaFin’s website (“Register unabhängiger Honorar-Anlageberater”).

Note:Record-keeping obligations

Investment services enterprises must document all inducements they have provided or received in an internal register. They must also document how these inducements enhance the quality of services provided to clients. Based on these records, BaFin can verify whether the enterprises comply with the requirements of the inducements regime.

What is so special about fee-based investment advice on an independent basis is that, unlike commission-based investment advice, it is to be paid only by the client. Conversely, this means that fee-based investment advisers may not accept and keep any inducements from the companies whose products they distribute. What’s more, they must try to avoid financial instruments and services for which an inducement is provided. If this is not possible in exceptional cases, for example because a financial instrument is not available without an inducement, fee-based investment advisers must return the inducements to the client as soon as possible and in full. Fee-based investment advisers may not even accept minor non-monetary benefits, such as information material or attending free training courses. This is because even the impression of potential influence must be avoided from the outset. These strict German rules on investment advice on independent basis have been in force for several years (see BaFinJournal July 2014 - only available in German).

Portfolio management

Portfolio management is becoming increasingly important for retail clients with smaller assets. One of the reasons for this is that digital – and hence often comparatively low-cost – asset management services are now becoming increasingly popular.

At a glance:Portfolio management

Portfolio management is also colloquially referred to as investment management. The key difference to investment advice is that the portfolio manager has a mandate to make the individual investment decisions for the client himself. The client limits the scope for decision-making in the portfolio management agreement, which defines the investment guidelines or strategy. As a rule, the portfolio manager reports quarterly on the performance of the client’s assets and any executed transactions.

Under MiFID II, portfolio managers may only accept minor non-monetary inducements such as information material or attending seminars on certain financial instruments – but only if they meet the conditions for the exemption, i.e. they disclose the inducement to the client and use it quality enhancement. For example, attending a training course on the benefits and features of a specific financial instrument can enable portfolio managers to better use their knowledge for the client.

Portfolio managers may not retain any other inducements. They must return or repay them to their clients as soon as possible. Therefore, investment services enterprises must establish appropriate processes.

Additionally, portfolio managers may not withhold inducements to offset them later against the portfolio management fee that the client has to pay. The reason is that the associated liquidity advantage could offer an incentive for portfolio managers to factor expected inducements into their investment decisions. As a general rule, the client should therefore always pay the fee for portfolio management directly.

Improved investor protection

The stricter rules of the inducements regime, and in particular the increased requirements for quality enhancement, reduce potential conflicts of interest and improve transparency. They are designed to protect investors and consumers. In addition, the rules take greater account of the statutory policy of a “ban on inducements with an exception”.

It remains to be seen whether they will also lead to increased fee-based investment advice on an independent basis offerings in Germany in the medium to long term, and whether clients will accept this to a greater extent than before.

Consumer tip:What should I pay attention to as a client?

The inducements regime protects you from conflicts of interest due to the payment of commissions when you use (ancillary) investment services. You can also help protect yourself.

  • Check whether the (ancillary) investment service is paid in part or in full by inducements. If you seek investment advice, the investment services enterprise must tell you before giving you advice whether it is advising you on an independent basis and whether it will be paid exclusively by you or not. If the service is (co-)financed by inducements, this fact must be disclosed to you.
  • Ask straight away if you don’t understand any information about the inducements. For example, if you are unclear about the way the inducement is calculated, ask for it to be explained to you in detail. That’s because a comparison with other offerings and providers is only possible if you have an in-depth understanding of the nature and scope of the inducement.
  • Get a clear idea about how commissions and other benefits can affect your investment advisor’s interests. But remember that the type of investment advice, regardless of whether it is independent fee-based or commission-based, does not necessarily influence whether you receive good or bad advice.
  • Bear in mind that the inducements will be paid out of the assets you have invested. Before your investment can generate a positive return, it first has to earn the costs, including the inducements. If there are high trail commissions, for example, consider whether the financial product in question can actually generate a sufficient return to cover them. If you’re not sure, always ask.

Authors

Lars Frölich
BaFin Division for Supervision of Compliance with Rules of Conduct and Investor Protection at Private & Foreign Banks

Dr Jörg Schneider
BaFin Division for Policy Issues, Consumer Protection

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