Explanatory Memorandum to COM(2010)371 - Amendment of Directive 97/9/EC on investor-compensation schemes - Main contents
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This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2010)371 - Amendment of Directive 97/9/EC on investor-compensation schemes. |
|---|---|
| source | COM(2010)371  |
| date | 12-07-2010 |
Directive 97/9/EC on Investor-Compensation Schemes (ICSD i) was adopted in 1997 to complement the Investment Services Directive i (ISD), the directive regulating, at that time, the provision of investment services in the EU. The ISD has since been replaced by the Markets in Financial Instruments Directive i (MiFID). The ICSD provides for clients receiving investment services from investment firms (including credit institutions) to be compensated in specific circumstances where the firm is unable to return money or financial instruments that it holds on the client's behalf.
Ten years after the ICSD entered into force, and immediately after the financial crisis, it is the right time to review the functioning of the ICSD. There is no concrete evidence to suggest that the financial crisis contributed to more compensation claims from schemes under the ICSD. However, in recent years, the Commission has received numerous investor complaints about the application of the ICSD in a number of important cases involving large investor losses. The complaints are principally related to the coverage and funding of schemes and delays in obtaining compensation. The review of the ICSD is also an important element, together with the review of the Deposit Guarantee Schemes Directive i and the examination of protection for insurance policy holders, of the Commission's policy to strengthen the EU regulatory framework for financial services as set out in the Communication on 'Driving European recovery' i. It also considers the objective set at G-20 level of addressing any loopholes in the regulatory and supervisory system and the objective of restoring investor confidence in the financial system.
This initiative is part of a broader package on compensation and guarantee schemes that will comprise two proposals for amendment of the Directives on Investor Compensation Schemes and on Deposit Guarantee Schemes and a White Paper on the insurance schemes.
The initiative is the result of an extensive and continuous dialogue and consultation with all major stakeholders, including securities regulators, market participants, national investor compensation-schemes and consumers. A call for evidence was submitted to public consultation from 9 February to 8 April 2009 i. Questionnaires were sent to national investor compensation schemes and a meeting was held with them on 9 February 2010 i. A targeted meeting was held on 3 September 2009 to gather views from industry and investor associations. This work is also built upon the observations and contributions from the European Markets Expert Group (ESME) i and the European Securities Committee (ESC) i. In addition it makes use of the findings of a study by OXERA, titled 'Description and assessment of the national investor compensation schemes established in accordance with Directive 1997/9/EC' (February 2005) i.
In line with its 'Better Regulation' policy, the Commission conducted an impact assessment of policy alternatives. Policy options were mainly related to the funding of the schemes, the payout delays, the coverage of the compensation and the level of compensation.
Each policy option was assessed against the following criteria: investor protection and confidence, level playing field in the protection provided for different types of investments or services in the EU and cost-effectiveness, that is the extent to which the option achieves the sought objectives and facilitates the operation of securities markets in a cost effective and efficient way i.
Contents
- LEGAL ELEMENTS OF THE PROPOSAL
- BUDGETARY IMPLICATION
- 2. CONSULTATION OF INTERESTED PARTIES
- 3. IMPACT ASSESSMENT
- 4.1. Legal basis
- 4.2. Subsidiarity and proportionality
- 4.3. Detailed explanation of the proposal
- 4.3.4. Exclusion of claims involving market abuse - Article 3 and Article 9(3)
- 4.3.6. Funding principles - Article 4a
- 4.3.7. Borrowing last resort mechanism between national schemes - Article 4b
- 4.3.10. Investor information- Article 10(1)
The proposal is based on Article 53 i of the TFEU.
The objectives of the proposal cannot be sufficiently fulfilled by the Member States. The current EU framework only provides for some minimum harmonisation principles leaving it up to Member States to develop it further. However, problems encountered in some Member States demonstrate that additional and notably more extensive harmonisation at EU level is necessary in order to ensure that the objectives of the Directive are fulfilled within the EU.
Indeed, the main problems with the application of the Directive are the large margin for discretion it grants to Member States. The proposal aims at improving the proper functioning of a single market for investment services, increasing investor protection and investor confidence in the EU. In particular, it aims at improving the practical functioning of the ICSD, at clarifying the scope of the ICSD taking into account the financial crisis and recent changes in the EU regulatory landscape, at reducing gaps in the regulatory system and disparities between the protection of clients of investment firms and of banking depositors. In the light of the existing differences in the functioning of the schemes at national level, the proposal introduces common rules to ensure a degree of harmonisation in the funding of the schemes and in the day-to-day practice; this is also the basis for the provision of a borrowing mechanism among national schemes as a last resort tool to compensate any temporary needs from schemes, subject to a rigorous assessment carried out by the European Securities and Markets Authority and to the obligation to repay any loan within the maximum period of five years.
Moreover, there are issues such as the current non-compensation of investors which due to the default of a depositary or third party cannot recover their assets or suffer a loss in the value of their units or shares in a UCITS, that need to be addressed at EU level, since other solutions could fragment the protection of investors in the EU markets. Taking into account that the provision of investment services is a cross border activity, investment firms should be treated in the same way in different Member States when they fail to return clients assets; investors across Member States should benefit from the same level of protection. This consistent approach is necessary in order to avoid level playing field problems between investment firms of different Member States and competition distortion between banks and investment firms.
An additional element relates to the fact that through the amendment of the Directive on Deposit Guarantee Schemes (Directive 94/19/EC i - DGSD), the level of protection for bank depositors was increased. Moreover, the functioning of the Deposit Guarantee Schemes is being modified in order to harmonise the scope of coverage, the modalities and timing of payout, the financing mechanisms and the provision of mutual solidarity between schemes. Investment firms should not be undermined due to the increase of protection in the bank deposits sector. Therefore it is necessary to assess the level of protection of investors at EU level, to take into account the situation of the markets in the EU and any regulatory change at EU level that might have consequences in the field of investments.
In the meantime, the proposal takes into account the different underlying objectives between the two directives. The DGSD has a prevailing banking stability objective because banks are susceptible to the risk of a run if depositors believe that their deposits are not safe and try to withdraw them at the same time. The ICSD protects investors against the risk of frauds or administrative malpractices or operational errors making the investment firm unable to return assets to clients. The proposal preserves the specificities of the sectoral legislation.
The proposal respects the principle of proportionality as all solutions have been assessed against its cost-efficiency and they respect the particularities of markets in Member States. The proposal does not go beyond what it is necessary to achieve the objectives pursued, in particular, it keeps minimum harmonisation principles where pertinent, for instance concerning the modalities according to which the members of the compensation schemes have to contribute to the scheme. The introduction of a borrowing system between the national schemes is consistent with the proportionality principle in that it does not impinge any fiscal responsibility of Member States, it is a last resort measure subject to the previous use of other funding mechanisms (ordinary and additional contributions from members), it only introduces a lending possibility subject to the payment of interests and to a repayment obligation from the borrowing scheme and it is limited in time and size.
4.3.1. Alignment with MiFID – Services covered and classification of clients – Article 1 i and Annex I
The scope of the ICSD is currently defined by cross-reference to investment services as defined under the Investment Services Directive i. The ICSD protects investors when a firm is unable to return financial instruments or money held on a client's behalf in connection with investment services.
MiFID has repealed the ISD and broadened the scope of services covered under the sectoral legislation (for example the operation of Multilateral Trading Facilities or MTF is currently included in the scope of MiFID). A number of technical issues have also arisen, such as the coverage of firms depending on the scope of their authorisation (i.e. whether the firm is authorised to hold client assets or not).
The proposed amendment clarifies that all investment services and activities covered under MiFID should be subject to the ICSD and that if firms de facto hold client assets (irrespective of restrictions on their authorisation or the nature of their investment service) then clients should be entitled to compensation under the ICSD. This would be irrespective of whether the firm is doing so in contravention of any limitation on its authorisation (e.g. preventing it from holding client assets or from dealing with retail clients) and irrespective of the nature of the investment service it provides (e.g. if it is operating an MTF). This measure will enable retail investors to assume that they are covered by the ICSD without checking detailed conditions on a firm's authorisation. It will also result in more consistency across Member States in the application of the ICSD which will assist the proper functioning of the ICSD.
Another amendment deriving from MiFID provisions concerns the classification of clients. Indeed, the ICSD is potentially applicable to all categories of investors. However, more sophisticated clients are normally able to select and monitor the activity of intermediaries to which they entrust their assets. In addition, the limitation of compensation to a certain amount (currently €20 000) makes the directive as typically targeted to 'small investors' i. For this reason, national legislation in the Member States may currently provide that professional and institutional investors i can be excluded from coverage i under Annex I of the ICSD.
However, since the ICSD pre-dates the MiFID, the list of professional and institutional investors under the ICSD does not coincide with the corresponding list under MiFID i. This may create complexities in the phase of compensation, where the clients classified as professionals for the provision of services may not correspond to the clients which may be excluded from coverage according to the ICSD.
The proposal aligns the classification of clients in the ICSD with the MiFID definition of clients to be considered as professional. This will provide greater consistency and clarity and simplify the position for compensation schemes and investors, as there will be consistency between the two Directives. The alignment with the clients to be considered as professional will ensure certainty and will also result in a better protection for medium-sized enterprises which may currently be excluded from the protection granted by the ICSD and are instead normally classified as retail clients under the MiFID i. A cross-reference to the MiFID definition of client to be considered as professionals will allow the automatic adaptation of the ICSD to any future MiFID change.
4.3.2. Failure of a third party custodian - Article 2 i, Article 12
The ICSD protects investors when a firm is unable to return financial instruments or money held on a client's behalf in connection with investment services. Under MiFID, financial instruments can be held in two different ways: (i) by the investment firm itself holding financial instruments for a client, or (ii) by a custodian (a 'third party custodian') usually selected by the firm i. Investors may therefore not only be exposed to the failure of the firm, but also to the potential failure of a custodian. In a case where a third party custodian is not able to return the financial instruments to its client, the client will not be able to benefit from any compensation payment by the compensation scheme established under the ICSD. This is because under the current scope of the ICSD, compensation schemes are only available to investors whose financial instruments have been lost by the investment firm "for reasons directly related to an investment firm's financial circumstances". As a result, there is under the ICSD a difference in the level of protection provided for investors who have purchased a financial instrument, depending on whether the firm itself or a third party custodian holds their assets.
The proposal amends Article 2 i to extend compensation to investors for claims relating to the failure of a firm to return financial instruments due to the failure of a third party custodian. This measure will deal with the potential gap that would arise if a custodian were to default. Investment firms remain responsible to take all reasonable steps to recover assets from a custodian.
The proposal does not amend the Article to include failure of an institution with whom monies are deposited by an investment firm. The reason for this difference is that the Directive 2006/73/EC Implementing MIFID provides for a very strict list of institutions where client funds may be deposited (a central bank, a credit institution, a bank authorised in a third country or a qualifying money market fund) i. This differentiates the treatment of funds compared with financial instruments, for which, subject to due diligence criteria from the investment firm concerned, entities which are not regulated might be appointed for the deposit of client financial instrument. This different regime justifies a different treatment under the ICSD.
4.3.3. Failure of a UCITS depositary - Article 1 i, Article 2 i, Article 2 (2b), Article 4a, Article 5, Article 10 i, Article 12
The management of Undertakings for Collective Investment in Transferable Securities (UCITS) i is not a MiFID investment service. As a result the ICSD does not cover UCITS and their units' holders in cases where losses are suffered due to the failure of a UCITS depositary or sub-custodian. This situation however is comparable, in substance, to the one describe under paragraph 4.3.2 where losses are suffered due to the failure of an investment firm custodian or sub-custodian.
As a consequence, the proposed measure will give UCITS holders the right to be compensated by the investor-compensation scheme if the assets cannot be returned to the UCITS, because of the failure of a UCITS depositary or sub-custodian. The definition of 'investor' under Article 1 i would encompass a unit holder in a UCITS and a series of articles are being modified in order to capture the failure of a UCITS depository or sub-custodian (Articles 2, 4, 5, 10, 12). Since the proposal will protect UCITS or UCITS depositaries or sub-custodians, the cost of this extension in coverage should be borne by these entities rather than investment firms. In addition, in light of the choice made to extend coverage of the ICSD in case of failure of a third party custodian used in connection with investment business, it makes sense that the risk is addressed in similar terms in the case of problems with depositaries or sub-custodians of the UCITS.
This measure will introduce some protection for UCITS investors. At the same time it should be complemented by changes to the legislation applicable to the UCITS depositaries function under the UCITS Directive i in order to further harmonise the depositaries' duties and their responsibility regime. The Commission is working on possible changes to that legislation i.
Article 3 of the ICSD excludes claims where a criminal conviction has been obtained for money laundering i but not claims by investors who have engaged in market abuse. By modifying Article 3, the ICSD will explicitly exclude any claim for compensation where the investor has engaged in actions that are prohibited under Directive 2003/6/EC on insider dealing and market manipulation i. The investors who have committed these acts should be excluded from compensation, as they should not benefit from the general protection offered by the Directive.
4.3.5. Level of compensation - Article 4 i and Article 2(3)
Article 4 i of the ICSD harmonizes the minimum level of compensation (€20 000) for each investor. When the ICSD was introduced, it was considered sufficient to align this level with the one set under the Deposit Guarantee Scheme Directive (€20 000 at the time) i. But the compensation limit of €20 000 was never adjusted to reflect inflation or the increased exposure of European investors to financial instruments since the ICSD entered into force. Furthermore, the Deposit Guarantee Schemes Directive (DGSD) was recently amended to provide for at least €50 000 per depositor per credit institution, to be increased to a fixed level of €100 000.[27]
The Commission proposes the modification of Article 4 i in order to increase the level of compensation to a fixed amount of €50 000. The level has been fixed to take account of the effects of inflation in the EU and to better align the level of compensation to the average value of investments held by retail clients in the EU. The level of compensation should be set at a fixed amount in order to avoid arbitrage and investors' choice to be influenced by any different coverage granted in different Member States. As some Member States have currently a higher level of compensation, a grandfathering clause of three years is foreseen to allow them to adapt to the €50 000 coverage level.
In the case of credit institutions doubts may arise as to the coverage under the ICSD rather than the DGSD of monies deposited in a bank in the context of the provision of investment services. To deal with situations of possible uncertainty due to the specific nature of banks which may provide both banking activity and investment services, the Article 2 i of the ICSD is being amended to specify that in cases of doubt the investor is to be compensated under the DGSD (which provided a higher level of coverage). This would protect investors in an efficient manner and reduce level playing field concerns.
The broad discretion under the ICSD about how to fund schemes (e.g. ex ante or ex post , in respect of the occurrence of any loss events) and huge differences in the way funding is organised by individual Member States create a number of problems. It undermines investor protection and investor confidence in the use of investment firms (if investors are not confident that there will be adequate funding in place to pay their claims if there is a default). It also affects the proper functioning of the internal market if the likelihood of investor protection, and the contributions required from firms, vary significantly across Member States depending on the adequacy of individual funding arrangements.
A new Article is introduced specifying the basic principles about the funding of the investor-compensation schemes. In particular, according to the provision:
- in principle, the cost of financing schemes should continue to be borne by market participants;
- the schemes should be adequately financed in proportion to their potential liabilities;
- in order to provide a sufficient level of funding, a minimum target fund level will be established for all the schemes. This target fund level will be fully ex ante funded. Taking into account the current differences at national level, the target fund level should initially be reached within a 10-year period;
- when, in concrete cases, the ex ante funds are not sufficient to cover the liabilities of a scheme, additional calls for contributions from entities covered under the scheme should be ensured. However, they should not jeopardise the stability of the financial system of the Member State;
- once these funding sources have been exhausted, the scheme may have recourse to borrowing from other compensation schemes as further detailed in the following point 4.3.7;
- access to further multiple funding sources has to be ensured, including borrowing facilities;
- schemes should publish details about their level of funding.
The detailed implementation of some points will be specified via delegated acts to be adopted by the Commission in accordance with Article 290 of the Treaty. The details to be made public by the schemes will be specified via technical standards by the future European Securities and Markets Authority (ESMA) i.
This measure is proportionate as it will result in more harmonisation of funding of schemes without being overly prescriptive and excessively detailed and it will still leave some flexibility to Member States as to the practical implementation of the principles. More harmonisation will improve the proper functioning of the single market for investment services by reducing discrepancies affecting the treatment of investment firms and investors in different Member States. It will also reduce the risk of a scheme having insufficient funding to meet its obligations and therefore result in greater consumer protection and investor confidence in the use of investment services.
Together with the establishment of consistent funding rules between Member States, the introduction of cooperation arrangements among national schemes will provide greater protection to investors and promote investor confidence in investment services.
The system is based on the principle of solidarity between the national schemes. According to the proposed Article, a borrowing mechanism among schemes is introduced as a last resort tool.
These measures should provide schemes with an alternative back up source of funding, under specific conditions and on a temporary basis. They will also facilitate a closer relationship and better on-going coordination between national schemes and will act as an incentive to develop more harmonized practices and working procedures. Detailed funding principles and a repayment (mid-term) obligation upon the borrowing scheme will limit the risk of moral hazard between undersized and better funded schemes. More in detail:
- schemes should have the right to borrow from the other schemes if their funds are insufficient to cover their immediate needs;
- a portion of ex-ante funding in each compensation scheme will have to be available for lending to other schemes;
- ESMA should receive any borrowing request, assess whether the relevant requirements are met and, if this is the case, transmit it to the other schemes;
- loans should be repaid to the lending schemes at the latest after 5 years since the request. Interests should accrue on the loans; the interest rate shall be equivalent to the marginal lending facility rate of the ECB;
- the borrowing mechanism should be limited to the claims covered under the Directive. For instance, schemes will not be able to borrow for any needs arising from the default of entities not included in the scope of the directive;
- in order to avoid that the funds available for lending at EU level are rapidly exhausted, a limit of 20% of the portion set aside for lending may be used for each case.
4.3.8. Compensation limit ("co-insurance principle") - Article 4 i, Article 8(1)
Article 4 i of the ICSD allows Member states to limit the coverage of the compensation to a specified percentage (equal to or exceeding 90%) of an investor's claim. This means that a client can be required to bear a proportion of the loss (within the compensation limit). The reason for this option in the ICSD was to encourage investors to take some care in choosing investment firms i. But arguably it is unrealistic to expect retail investors to be able to identify which firms are more or less likely to be affected by fraud or systems failures.
Eliminating this option under Article 4 i will provide increased investor protection under the ICSD as clients will no longer have to bear part of the loss if there is fraud at a firm or other problems with the firm's systems or controls.
Moreover, in order to better protect investors, the provision giving the possibility to Member States to exclude from coverage of the compensation scheme funds in currencies other than of the Member States is eliminated. This provides better protection to investors as it ensures that clients' funds are covered irrespective of the currency involved.
4.3.9. Payout delays – Article 2, Article 9(2)
Article 9 i of the ICSD establishes a strict deadline for reimbursement (as soon as possible and at the latest within three months). But, this deadline only runs once the 'eligibility and the amount of the claim' have been established. That is, it is not linked to the date on which the firm is declared to be in default. Processing claims takes considerably longer than the limits set, possibly up to several years as evidenced by recent cases. So in practice there is a considerable delay before an investor receives any compensation. This undermines investor protection and investor confidence.
The proposed modification to Article 9 i introduces the obligation for schemes to provisionally pay partial compensation based on an initial assessment of the claim if payout delay exceeds a specified time period. The level of the partial payment will amount to one third of the initial assessment of the claim. The balance will be paid out later once the claim had been fully verified. Schemes will also need the ability to recover amounts provisionally paid out if it was subsequently determined that the claim was not in fact valid.
Article 2 is also being amended to clarify that a competent authority must make a determination of whether a firm is unable to meet its obligations to investors within three months. This is to mitigate concerns about individual cases where competent authorities could be very slow to make a determination.
The delays introduced by the proposal take into account the difference between situations covered under the ICSD and the DGSD, where depositors must be repaid within 20 working days of the date on which the authorities make their determination as to the inability of credit institutions to repay the deposits. In the case of compensation-schemes, the underlying situations of fraud, malpractices or operational problems covered by the directive make it necessary a longer delay in order to reconstruct the position of single investors.
Article 10 i of the ICSD requires Member States to ensure that investment firms make available to actual and potential investors information about the relevant investor compensation scheme including the amount and scope of cover. Information must be made available in a readily comprehensible manner. However, concerns have been raised about how this provision has been applied in practice in the Member States.
Article 10 i is amended to require also to UCITS managers, as a consequence of the broadening of coverage of the Directive, to disclose to investors in clear and simple terms what is effectively covered by schemes (e.g. investment risk is usually not covered). Under this proposal the existing obligation for investment firms to provide information about compensation schemes to new clients will be supplemented by requiring further detail to be provided about what is compensated under the ICSD and how it applies in cross border situations, also for UCITS. Specifically it will require them to clearly explain that certain losses (e.g. due to investment risks) are not subject to the payment of compensation under the ICSD.
The proposal has no implication for the Union budget