MIFID and Client Assets
Author:
Patrick Connolly
The introduction of the Markets in Financial Instruments Directive (MIFID) in Ireland by statutory instrument in 2007 has changed the legislative framework under which auditors report on client assets. Patrick Connolly explains the background and outlines where the main impact will be.
With effect from 1 November 2007, investment firms are no longer subject to the provisions of the Investment Intermediaries Act, 1995 but instead are regulated by the European Communities (Markets in Financial Instruments) Regulations, 2007 (the ‘Regulations’).
The Stock Exchange Act, 1995 and associated EU Investment Services Directive 93/22/EC have both been replaced by the Regulations. The Financial Regulator has issued Client Asset Requirements, as provided by Regulation 79 of the Regulations, and these replace the Client Money Requirements previously issued in 2004.
Regulation 144 (1) contains the requirement for auditors to report to the Financial Regulator on the adequacy of an investment firm’s arrangements to safeguard client assets. General principles regarding these arrangements are set out in the Regulations, and more detailed guidance (and rules) is provided by the Financial Regulator in the Client Asset Requirements.
This article summarises the impact of MIFID, particularly in relation to these requirements, and the extent to which it will impact on auditors reporting on client assets.
Scope
The Regulations apply to investment firms. An investment firm provides investment services to third parties or undertakes investment activities on a professional basis. Investment services are listed in Schedule 1 to the Regulations and include execution of orders in relation to financial instruments, portfolio management and investment advice. Tied agents are not considered investment firms. The categories of firm likely to fall under the definition of investment firm are as follows:
-stockbrokers,
-investment banks,
-portfolio managers,
-investment advisers,
-corporate finance firms,
-some commodities firms, and
-some futures and options firms.
There are a significant number of exemptions available to different entities stating that the regulations do not apply to those entities. These are stated in Regulation 5.
Exemptions include: insurance undertakings, entities providing investment services exclusively to subsidiaries or parent entities, collective investment schemes and pension funds.
A small number of entities will continue to be subject to the Investment Intermediaries Act, 1995 because they meet the definition of an investment business firm contained in the Act, but do not meet the definition of an investment firm contained in the regulations.
Such entities include managers of designated investment funds and persons acting as deposit agents or deposit takers. These entities are however also subject to the client asset requirements.
Impact of MIFID
The Regulations implement the MIFID Directive, which provides investment firms with an effective ‘single passport’ to provide services across the European Union on the basis of home country authorisation. This should increase competition across borders within Europe. At the same time, investor protection rules have been harmonised at a high level across Europe, and these cover: best execution, information to clients, order handling, investment advice, inducements and conflicts of interest.
Trading in shares other than on a stock exchange is provided for, as is increased transparency – MIFID requires firms to publish their off exchange purchases and sales of shares admitted to trading on a regulated market in the European Economic Area.
Finally, the Directive is a ‘maximum harmonisation’ directive, which means that member states are generally not permitted to introduce any extra measures over and above those set out in the directive.
The investor protection objective is addressed in Regulation 33, Regulations 160 to 162 and also in the related Client Asset requirements. In many ways the client asset requirements have not significantly changed from the pre-existing client money requirements, but some of the more important changes are noted below.
Client Asset Requirements
The introduction of the Markets in Financial Instruments Directive (MIFID) in Ireland by statutory instrument in 2007 has changed the legislative framework under which auditors report on client assets. The Financial Regulator has responded by issuing new client money requirements, which have been renamed the Client Asset Requirements.
The auditors’ responsibilities under the Client Asset Requirements are unchanged from those under the client money requirements. However, in performing their testing, auditors should note the following changes to the client money requirements contained in the Client Asset Requirements:
-The rules now distinguish between retail clients and professional clients in terms of the information that must be provided.
The obligation to provide clients with a statement of client assets has been reduced from every six months to an annual requirement.
Firms can now hold client money by investing in money market
funds.
Firms that did not hold client assets but had control over them were subject to the client money requirements but are not subject to the client asset requirements. For example, such firms would include an investment manager having instructions over a client account with a custodian.
Report to the Financial Regulator
In September 2006, the Institute of Chartered Accountants in Ireland (ICAI) issued Miscellaneous Technical Statement M47 Guidance for reporting in accordance with the Client Money Requirements issued by the Financial Regulator. The statement provided guidance to auditors of investment businesses and stockbrokers on the nature and extent of work required when reporting under the Investment Intermediaries Act, 1995 or the Stock Exchange Act, 1995. M47 contains two example reports by auditors to the Financial Regulator for an investment business firm and for a stock exchange member firm. The two example audit reports, contained in the Appendix to the M statement, need to be amended to reflect the new Regulations as follows:
‘Section 52 of the Investment Intermediaries Act’ should be replace with ‘Regulation 33 (1) (h) and (i) and Regulations 160 to 162 of the European Communities (Markets in Financial Instruments) Regulations 2007 (Nos.1 and 2)’
‘Section 52 of the Act (the client money requirements)’ should be replaced with ‘Regulation 79 (theClient Asset Requirements)’
‘client money requirements’ should be replaced with ‘client asset requirements’
‘Section 52 of the Stock Exchange Act, 1995’ should be replaced with ‘Regulation 33 (1) (h) and (i) and Regulations 160 to 162 of the European Communities (Markets in Financial Instruments) Regulations 2007 (Nos.1 and 2)’.
In a small number of instances, an entity may continue to be subject to the Investment Intermediaries Act, as noted above. Such entities will continue to use the report given as example 1 in Appendix 2 of the M statement.
Respective Responsibilities of Directors and Auditors
The responsibilities of directors as set out in the example audit reports in M47 need to be amended to take account of the following:
‘Section 52 Account’ should now be referred to as a ‘Client Asset Account’ (this is to comply with the client asset requirements).
Investment firms can now hold client money by investing in money market funds (this should be noted in point (b) of the example).
Client Money Requirements are now referred to as Client Asset Requirements.
The requirement to keep books and records at an office or offices within the state which was contained in Section 52 has not been retained in the Regulations. Instead the Regulations require that an entity keep such records and accounts as are necessary to enable them at any time and without delay to distinguish assets held for one client from assets held for any other client, and from their own assets.
Apart from changes to the example audit reports, M47 requires little amendment when applied in respect of the Client Asset Requirements. M47 provides examples of procedures that management may implement to address the control objectives in the Client Asset Requirements. However it states that these are only examples and the details will vary between investment business firms. The ICAI has indicated that M47 will be updated in due course.