EIS 2018 report (web)

26 27 COMPLIANCE CONSIDERATIONS IMPLEMENTING MIFID II After numerous delays, the EU directive, MiFID II came into effect on January 3 2018. The new legislation came into play regardless of Brexit - due to the implementation occurring before the UK’s full exit from the European Union. MiFID II has a broad scope, but primarily seeks to improve transparency for retail investors. The FCA has also stated that the UK will comply fully with MiFID II, and in some cases, the FCA will go above the scope of the directive by “gold plating” certain elements. For example, MiFID II is primarily focused on listed securities, whereas the FCA’s approach seeks to implicate private equity firms as well. 30 SUITABILITY One of the key considerations for compliance with MiFIID II is suitability - which is particularly pertinent, due to the high risk nature of EIS investments. The directive does not fundamentally change the requirements already applicable to UK advisers. However, Susann Altkemper, counsel for City law firm CMS, noted that it does “impose a new obligation on investment advisers to provide suitability reports to retail clients before any transaction is concluded”. She explains: Advisers will also be required to produce suitability reports where their advice does not lead to a transaction - meaning that quite an extensive library of file notes will have to be kept. From the fund manager’s perspective, under MiFID II a fund must state what its target market is, meaning that there has to be a far greater focus on appropriateness. It’s worth noting that the burden for client suitability is not completely left to the adviser. Advisers are not required to advise on each of the underlying companies in an EIS portfolio, as the EIS fund manager takes responsibility for selection of individual companies. 32 One EIS provider, Octopus Investments, issued a note in response to MiFIID II, regarding its VC funds (which includes reference to its, now closed, EIS fund). CALL RECORDING AND REPORTING All advisers will be required to record all forms of communication with their clients, this is not merely limited to phone calls, but will also include any social media interactions (such as Whatsapp, Facebook Messenger, and Linkedin). ALERTING 10% LOSSES MiFID II introduces a new 10% rule whereby investors have to be alerted on the same day to changes to their portfolio of 10% or greater. This may be particularly burdensome for EIS managers, due to the inherently volatile nature of the underlying investments in early stage companies. The responsibility for communication of a portfolio drop is left to the discretionary fund manager. DISCLOSURE OF CHARGES Costs and charges will now have to be communicated to investors in four key categories for each fund: The ongoing charge. One-off fees such as entry and exit charges. Incidental fees, such as performance charges. Transaction fees relating to the investment product. With regards to the EIS space, the fee structure is certainly not uniform across different providers and portfolios. Our analysis of open EIS offers in our Sector Analysis section illustrates a myriad of fees such as: AMC (annual management charges), initial charges, performance fees, as well as less common charges such as initial deal fees, exit deal fees and annual admin charges. Although the actual fees won’t change, implementing a more transparent and standardised format for how fees are communicated to investors will certainly be advantageous for the EIS industry, and may encourage further investment. UNBUNDLING RESEARCH COSTS Another measure implemented under the new directive is to unbundle and reveal the costs of research for investment managers, so as to show that investment firms are not being induced to trade. EIS investment managers may be affected less in this respect than the greater investment universe, due to the nature of the smaller, unlisted companies that EIS encompasses. As a result, most investment providers do their research in-house, with the exception of EIS companies that are AIM-quoted, where there may be further research available at a cost from third parties such as brokers. Consequently, for the most part, from the advisers’ perspective, little will change in terms of research costs. Although, if the adviser is paying a third party service for due diligence on EIS funds, then it will have to clearly show the cost to the investor. However, even if the investment manager has provided the adviser with free research, it may not be considered to be an inducement, as long as the research is considered to be an “acceptable minor non-monetary benefit” 34 , which is defined in the FCA Handbook under COBS 2.3A.19. Nevertheless, if an adviser receives research that is not considered to be an acceptable minor non-monetary benefit, an inducement will be considered to have occurred. PLATFORM TRANSPARENCY Although EIS is not typically available on mass market investment platforms, there are specialist platforms that cater to this space. Under MiFID II, transparency over platform costs will have to increase. Investors will be able to have a clearer, segmented view of the platform costs paired with fund costs. PRIIPS AND EIS EU legislation on PRIIPs (Packaged Retail Investment Products) was also implemented on January 3. Much like Mifid II, PRIIPs had been delayed by 12 months. One element that applies to EIS is the requirement for a KIID (key investor information document) for all investments. KIIDs must outline the product’s aims, how risky it is, when investors get their money back, how much it costs and expected returns. All the information must be set out in a standard way, regardless of the type of investment product. KIIDs could be beneficial for EIS by giving the documentation a standardised, mainstream appearance, and allowing easier comparison between products. However, this does put an extra burden on fund managers in terms of compliance workload. “MiFID II introduces a new 10% rule whereby investors have to be alerted on the same day to changes to their portfolio of 10% or greater. ” In practice, this might be difficult to achieve, and unless advisers can rely on a narrowly drafted exception, they will need to adjust their processes or consider changes to business models altogether. 31 For applications for our Investment Services, we have made it clearer that we expect advisers to ensure that the service they are recommending is suitable for their client. This has always been part of our Terms of Business for intermediaries, but we are now asking advisers to sign the application form to verify that they have conducted a suitability assessment. 33