moloney - how to protect investors; lessons from the ec and the uk (2010)

The financial crisis and EC retail market policy 41 2 Designing a retail investor protection regime 45 I.. A number of these are reveal-ing as to the direction of the policy debate on re

As governments around the world withdraw from welfare provision and promote long-term savings by households through the financial markets, the protection of retail investors has become critically important Taking

as a case study the wide-ranging EC investor-protection regime which now governs EC retail markets after an intense reform period, this critical, con- textual and comparative examination of the nature of investor protection explores why the retail investor should be protected, whether retail investor engagement with the markets should be encouraged and how investor- protection laws should be designed, particularly in light of the financial crisis The book considers the implications of the EC’s investor-protection rules ‘on the books’ but also considers investor-protection law and policy

‘in action’, drawing on experience from the UK retail market and in ticular the Financial Services Authority’s extensive retail market activities, including the recent Retail Distribution Review and the Treating Customers Fairly strategy.

par-niamh moloney is a professor in the Law Department of the London School of Economics and Political Science.

financial market regulation

Recent years have seen an upsurge of change and reform in corporate law and financial market regulation internationally as the corporate and institutional investor sector increasingly turns to the international financial markets This follows large-scale institutional and regulatory reform after a series of

international corporate governance and financial disclosure scandals exemplified

by the collapse of Enron in the US There is now a great demand for analysis in this area from the academic, practitioner, regulatory and policy sectors.

The International Corporate Law and Financial Market Regulation series will

respond to that demand by creating a critical mass of titles which will address the need for information and high-quality analysis in this fast developing area.

Series Editors

Professor Eilis Ferran, University of Cambridge

Professor Niamh Moloney, London School of Economics and Political Science Professor Howell Jackson, Harvard Law School

Editorial Board

Professor Marco Becht, Professor of Finance and Economics at Universit´e Libre

de Bruxelles and Executive Director of the European Corporate Governance Institute (ECGI).

Professor Brian Cheffins, S J Berwin Professor of Corporate Law at the Faculty

of Law, University of Cambridge.

Professor Paul Davies, Cassel Professor of Commercial Law at the London School of Economics and Political Science.

Professor Luca Enriques, Professor of Business Law in the Faculty of Law at the University of Bologna.

Professor Guido Ferrarini, Professor of Law at the University of Genoa and Honorary Professor, Faculty of Law, University College London.

Professor Jennifer Hill, Professor of Corporate Law at Sydney Law School Professor Klaus J Hopt, Director of the Max Planck Institute of Comparative and International Private Law, Hamburg.

Professor Hideki Kanda, Professor of Law at the University of Tokyo.

Professor Colin Mayer, Peter Moores Professor of Management Studies at the Sa¨ıd Business School and Director of the Oxford Financial Research Centre James Palmer, Partner of Herbert Smith, London.

Professor Michel Tison, Professor at the Financial Law Institute of the University

HOW TO PROTECT INVESTORS

Lessons from the EC and the UK

NIAMH MOLONEY

Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore,

São Paulo, Delhi, Dubai, Tokyo

Cambridge University Press

The Edinburgh Building, Cambridge CB2 8RU, UK

First published in print format

ISBN-13 978-0-521-88870-7

ISBN-13 978-0-511-67557-7

© Niamh Moloney 2010

2010

Information on this title: www.cambridge.org/9780521888707

This publication is in copyright Subject to statutory exception and to the

provision of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press.

Cambridge University Press has no responsibility for the persistence or accuracy

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Published in the United States of America by Cambridge University Press, New York www.cambridge.org

eBook (NetLibrary) Hardback

Preface and acknowledgments pagexiii

Table of cases xvii

Table of treaties and legislation xviii

List of abbreviations xxv

1 The retail investor and the EC 1

I The importance of the retail markets 1

II The retail markets and the EC 5

1 The development of a retail market agenda 5

2 Scope: the reach of EC investor protection law and policy 13

3 Beyond the cross-border context 18

4 But room for local ‘law on the books’ and for ‘law in action’: the

5 Examining retail investor protection through the EC lens 29

III Who is the EC investor? 30

1 Characterizing the target of investor protection 30

2 The average EC investor: an elusive target? 31

3 Investors or consumers? 39

IV The financial crisis and EC retail market policy 41

2 Designing a retail investor protection regime 45

I Why intervene in the retail markets? Encouraging the empowered investor, shielding the irrational investor or supporting the trusting investor? 45

1 Characterizing investor protection 45

2 The retail investor as an agent of public policy and the

empowered investor 47

3 The irrational and uninformed investor 67

4 The trusting investor 81

II The risks of retail market intervention 92

1 Regulatory and retail market agenda risks 92

vii

2 Regulation and the retail markets: ‘laws on the books’ and ‘laws in action’ 95

3 Responding to the drivers of retail market engagement 97

4 Centralization risks 100

III How to intervene on the retail markets? 102

1 The regulatory toolbox and self-regulation 102

2 Achieving retail market outcomes 106

3 Principles-based regulation and the retail markets 108

4 Evidence-based policy formation and rule-making 114

5 Controlling risk-taking and segmentation techniques 118

6 Diversification 122

3 Product regulation 134

I Product regulation and the retail markets 134

1 The EC and product regulation 134

2 The benefits of CIS product regulation 137

3 The risks of CIS product regulation 142

4 An integrated model 151

II The UCITS investor protection regime and product regulation 152

1 Inbuilt diversification and liquidity 152

2 Inbuilt governance: the depositary and the management

III The UCITS III product and design risks 157

1 The UCITS III regime 157

2 UCITS III and the risks of facilitative product design 162

3 Beyond UCITS III: alternative investments and product

design risks 168

4 Beyond product regulation: the product provider and the

provider/distributor relationship 176

IV Structured and substitute products 179

1 The substitute product market and structured products 179

2 A segmented product regime and its risks 184

3 Developing a response 187

4 Investment advice and product distribution 192

I Intermediation, its risks and regulation 192

1 The benefits of advice 192

2 The risks 193

3 Regulating advice 196

II Scope of the advice and product distribution regime 200

1 The advice and distribution regime 200

2 MiFID’s scope: a wide range of instruments and services 202

3 MiFID’s scope: the pivotal investment advice definition 203

4 MiFID’s scope: supporting access to advice? 204

5 MiFID’s scope: the nature of investor protection ‘on the books’ 207

III Regulatory design choices 209

1 Regulatory design choice (1): maximum harmonization 209

2 Regulatory design choice (2): principles-based regulation 212

3 Regulatory design choice (3): shaping firm conduct and the

eclipsing of disclosure 213

IV Regulatory technique (1): the fairness principle and ‘law in action’ 215

1 The fair treatment principle 215

2 The risks of ‘fairness’ 217

3 Fairness and the TCF model: ‘law in action’ 219

4 The implications of the TCF model 223

V Regulatory technique (2): marketing risks 224

1 Marketing risks 224

2 Delivery-specific protection: online and distance contacts 226

3 Horizontal protection: consumer protection directives 227

4 Investment-specific protections: MiFID 231

VI Regulatory technique (3): quality of advice and suitability 235

1 Suitability and objective advice 235

2 The suitability regime: suitability and appropriateness 237

3 Suitability ‘in action’ 240

VII Regulatory technique (4): conflict-of-interest management 244

1 Conflict-of-interest risks 244

2 MiFID and retail market conflict-of-interest risk 245

VIII Regulatory technique (5): the investment firm/investor contract 247

IX Segmentation risks 250

1 The UCITS regime 250

2 Structured and substitute products 252

X Advice or sales? Addressing the ‘right risks’ 256

1 Delivering high-quality investment advice 256

2 Incentive and commission risks: advice or sales? 257

3 MiFID and commission risk 263

XI Fee-based investment advice: segmenting regulated advice 266

1 Delivering independent investment advice: the UK Retail

Distribution Review and other international experience 266

2 An EC model? 273

XII Access to mass market advice and the sales problem 278

1 Access to advice 278

2 A mass market advice regime and MiFID: generic advice 279

3 Access to advice and the UK experience 279

4 The EC and access to advice 285

5 Disclosure 288

I Disclosure and EC investor protection 288

1 The retail market disclosure regime 288

2 The investor understanding problem 290

3 The risks of disclosure 296

4 Disclosure ‘in action’ 300

II Investment product disclosure (1): the UCITS regime 304

1 Designing CIS disclosure: the challenge 304

3 Conflicts of interest and commissions 337

6 The trading process 345

I Promoting access to trading 345

1 Better diversification and lower trading costs 345

2 The risks and execution-only services 350

II Investor protection in the trading process 354

1 A matrix of rules 354

2 Best execution 355

3 Trading and issuer disclosure 363

7 Education and governance 374

I Investor education 374

1 Investor education 374

2 Building an investor education strategy: the UK example 384

3 Investor education and EC retail market policy 389

II Retail investor involvement in policy formation and law-making 398

1 Retail investor involvement 398

2 Retail governance and the EC 399

3 Improving investor governance 413

4 CESR and the retail markets 419

8 Supervision, enforcement and redress 426

I Public supervision and enforcement in the retail markets 426

1 Public supervision and enforcement in the retail markets 426

2 The EC regime 426

3 Risks to the retail markets 429

4 CESR, the retail markets and supervisory convergence 436

5 Investor compensation schemes 440

II Investor redress 442

1 Access to justice and the retail investor 442

2 Direct retail investor action 444

3 Collective action 458

Index 464

This book is concerned with the protection of retail or household investors.The retail markets can be something of a Cinderella in financial marketregulation The regulatory challenges can be humdrum but intractable, theretail constituency quiescent and unhelpful to the beleaguered regulator,and the empirical and analytical pyrotechnics of law and finance and oflaw and economics, typically applied to financial market regulation, oftenoverlook this area; behavioural finance is, however, now taking up some

of the empirical heavy lifting But, as governments withdraw from welfareprovision and promote stronger long-term household saving, the retailmarkets have become of central importance; to borrow a phrase from lawand finance, they ‘matter’ So does investor protection regulation and how

it is developed and designed

This book accordingly addresses three questions Who is the retailinvestor (chapter 1)? Why should that investor be protected (chapter 2)?How should protection be designed (chapters 3– )? It considers whetherinvestors are best characterized as empowered, irrational or trusting, andconsiders the implications for regulatory design Its case study is the mas-sive EC harmonized regulatory regime for Member States’ retail invest-ment markets which provides a rich case study of investor protection law

‘on the books’ But effective retail market protection depends heavily on

‘law in action’, which remains largely the preserve of the Member States.The book’s main case study for domestic ‘law in action’ is the UK and, inparticular, the retail market activities of the Financial Services Authority

A note on the European terminology used is necessary The book islargely concerned with the internal market aspect of the European Unionand so generally refers to the European Community, the EC and the ECTreaty At the time of writing, the Lisbon Treaty had not been ratified by allthe Member States If the Treaty comes into force, the relevant EC Treatyprovisions will not change in substance, but will be incorporated into thenew Treaty on the Functioning of the European Union, and references to

xiii

the EC or European Community in this book should be read as references

to the EU or European Union

This book entered its final stages against the backdrop of the financialcrisis In the maelstrom, as regulatory and governmental attention focused

on safety and stabilization, retail investor interests have been largely shadowed Household wealth has, however, been destroyed, investor trusthas been badly shaken and the policy drive to encourage stronger market-based saving seems quixotic, at least at first glance Nonetheless, as thisbook argues, the difficult task of designing an effective investor protec-tion system and of supporting household engagement with the marketsmust go on Much greater evidence is needed on how investors thinkand behave (chapter 2) Hard questions concerning the degree to whichinvestors should be allowed to access more complex products must beanswered, particularly given the losses related to structured products overthe crisis (chapter 3) Disclosure, the great panacea of modern investorprotection, seems all the more a troublesome device (chapter 5) As dis-cussed inchapter 7,the voice of the retail investor, however ill-informedand erratic that voice may be, has been largely absent from the policydebate on the crisis This must change

over-The book aims to state the law and major policy developments as at

31 May 2009 although it has been possible to make some very brief ences to subsequent major developments A number of these are reveal-ing as to the direction of the policy debate on retail investor protection.Most notably, perhaps, the Obama Administration’s blueprint for regu-

refer-latory reform (Department of the Treasury, Financial Regurefer-latory Reform

(2009)), which took as a key objective the protection of consumers andinvestors from financial abuse, includes significant institutional reform inthe form of a new Consumer Financial Protection Agency which will shareresponsibility with the Securities and Exchange Commission for protect-ing consumers of financial services From an EC perspective, much can

be learned from the emphasis being placed on the Agency’s gathering of

‘actual data about how people make financial decisions’ Otherwise, there

is dishearteningly little evidence of any attempts to gather meaningful data

on how household investors reacted to the crisis; the European sion’s 2009 Eurobarometer survey on the crisis was limited to a survey

Commis-of reaction to the EU’s general efforts (Standard Eurobarometer (EB 71),

Europeans and the Economic Crisis (2009)).

Institutional reform has also been a major theme of the EC response

to the crisis, although here the retail interest was not the driving factor(chapter 7) The Commission’s September 2009 proposals for a European

System of Financial Supervisors and, in particular, for a central EuropeanSecurities and Markets Authority (which followed the Commission’s May

2009 Communication on supervision and the agenda-setting de Larosi`ereReport) promise much for better pan-EC prudential supervision But theimpact on retail market law-making is not yet clear, although the pro-posed Authority will have the power to adopt binding technical standards(endorsed by the Commission) Some efforts are, however, being made

to engage the retail sector with the Authority’s work through enhancedconsultation procedures (via a Stakeholders Group) The proposed JointCommittee of European Supervisory Authorities may also lead to bettercross-sectoral law-making, although institutional segmentation betweenthe banking, insurance/pensions and securities sectors persists in the newmodel The initial failure to engage with the retail sector during the impor-tant de Larosi`ere discussions remains disheartening (chapter 7) The crisishas, however, galvanized FIN-USE, the EC’s forum for the consumer inter-est in financial services, to produce a number of papers, significant by their

very adoption, on the crisis (including FIN-USE, The Future of Financial

Services Supervision (2009)) Otherwise, and perhaps reassuringly given

persistent governance and evidence-gathering weaknesses, there was little

in the way of knee-jerk reaction, with the 2009 Commission nication on the treatment of substitute investment products emergingfrom a discussion which pre-dated the crisis, although the crisis may haveencouraged the Commission to adopt what is a relatively radical reformagenda

Commu-Similarly, in the UK, prudential and stability matters have been to thefore, although the FSA did proceed with the next stage of its massiveRetail Distribution Review in June 2009, presenting specific reform pro-posals designed to address persistent and entrenched conflicts of interest

in the commission-based UK investment advice and product distributionindustry (Consultation Paper 09/18) The proposals broadly reflect theFSA’s final thinking on the Review in 2008 (chapter 4) Investment adviceconcerning a broad range of substitute ‘retail investment products’ will besegmented into ‘independent advice’ and ‘restricted advice’ ‘Independentadvice’ must be unbiased, unrestricted and based on a comprehensiveand fair analysis of the relevant investment product market Advice mustotherwise be labelled as ‘restricted’, including where a firm advises only

on proprietary products A new adviser charging model will apply to allinvestment advice; the current commission-based system will be prohib-ited A new professional standards regime for all investment advice willalso be adopted

Overall, however, there is little evidence of a policy concern, post-crisis,

to rethink how investor protection is delivered The dominant assumptionsconcerning investor empowerment, investor competence and the investor’scarrying of market risk remain in place

The completion of this book was supported by a Research Leave Awardfrom the Arts and Humanities Research Council which I very grate-fully acknowledge Cambridge University Press, in particular Kim Hughesand Daniel Dunlavey, oversaw the book’s production with great cour-tesy and efficiency I would also like to thank the many people fromwhose work I have learned; in particular, I owe a great deal to Profes-sors Eil´ıs Ferran, Guido Ferrarini, Klaus Hopt, Howell Jackson, DonaldLangevoort, Stephen Weatherill and Eddy Wymeersch, whose scholarshiphas inspired me

My greatest inspiration is my wonderful husband, Iain This book isdedicated to him

Niamh Moloney

1 October 2009

Alpine Investments BV v Minister van Financi¨en [1995] ECR I-1141 (Case C-384/93)

EC Treaty and EC legislation

Consolidated Life Assurance Directive 2002/83/EC 323

Deposit Guarantee Directive 1994/19/EC 42, 442

Distance Marketing of Financial Services Directive 2002/65/EC 8 , 14 , 21 , 40, 57,

E-Commerce Directive 2000/31/EC 7, 227, 334

Injunctions in the Consumer Interest Directive 1998/27/EC 459, 460

xviii

Investment Services Directive 1993/22/EC 7 , 203

Investor Compensation Schemes Directive 1997/9/EC 42 , 63 , 441 , 442

Legal Aid Directive 2002/8/EC 447

Market Abuse Directive 2003/6/EC 364, 366, 369, 403

Investment Advisers Act 1940 267

Securities Exchange Act 1934 267

3L3 three Level 3 Committees (CESR, CEBS and CEIOPS)ADR alternative dispute resolution

AFM Autoriteit Financi¨ele Markten (Dutch regulator)

AMF Autorit´e des March´es Financiers (French regulator)APCIMS Association of Private Client Investment ManagersASIC Australian Securities and Investments CommissionBaFIN Bundesanstalt f¨ur Finanzdienstleistungsaufsicht (German

regulator)

CDO collateralized debt obligation

CEBS Committee of European Banking Supervisors

CEIOPS Committee of European Insurance and Occupational

Pensions Supervisors

CESR Committee of European Securities Regulators

CFD contract for difference

CIS collective investment scheme

CNMV Comisi ´on Nacional del Mercado de Valores (Spanish

regulator)

COBS Conduct of Business Sourcebook

CONSOB Commissione Nazionale per le Societ`a e la Borsa (Italian

ECOSOC European Economic and Social Committee

EFAMA European Fund and Asset Management AssociationESC European Securities Committee

ESME European Securities Market Expert Group

FESE Federation of European Securities Exchanges

FIN-NET Financial Dispute Resolution Network

xxv

FIN-USE Forum of User Experts in the Area of Financial ServicesFINRA Financial Industry Regulatory Authority

FSA Financial Services Authority (UK regulator)

FSAP Financial Services Action Plan

FSCG Financial Services Consumer Group

FSCP Financial Services Consumer Panel

FSMA Financial Services and Markets Act 2000

ICMA International Capital Market Association

ICSA Institute of Chartered Secretaries and AdministratorsIDD Initial Disclosure Document

IMD Insurance Mediation Directive

IOSCO International Organization of Securities CommissionsISA Individual Savings Account

ISD Investment Services Directive

ISDA International Swaps and Derivatives Association

KII Key Investor Information

MiFID Markets in Financial Instruments Directive

MPBR more-principles-based regulation

MTF multilateral trading facility

NASD National Association of Securities Dealers

OAM officially appointed storage mechanism

OECD Organization for Economic Co-operation and

Development

RDR Retail Distribution Review

RSP retail service provider

SCDD Services and Costs Disclosure Document

SEC Securities and Exchange Commission (US regulator)TCF Treating Customers Fairly

UCITS Undertakings for Collective Investment in Transferable

Securities

UCP Unfair Commercial Practices Directive

The retail investor and the EC

I The importance of the retail markets

This book examines the nature of retail investor protection It considers theprotections which do, and those which should, apply to individual, privateinvestors1 who purchase investment products, take investment advice,carry out direct trading and, overall, engage in short-term speculation orlong-term savings through market-based instruments.2

Its case study is the massive EC regulatory regime for the retail ment markets This regime has grown exponentially in recent years andnow dictates the nature of retail investor protection ‘on the books’ for thetwenty-seven Member States of the European Union But, as discussedthroughout the book, retail market protection is not simply a function of

invest-‘law on the books’ Effective retail market protection depends heavily on

‘law in action’.3And ‘law in action’, in terms of, for example, innovativesupervisory strategies, product design initiatives, retail market research,investor redress and investor education, is largely the preserve of the Mem-ber States The book’s main case study for domestic ‘law in action’ is the

UK and the Financial Services Authority’s increasingly strenuous efforts inthe retail markets.4But the book adopts a generally comparative approach,

1 Although the terms ‘consumer’ and ‘investor’ are sometimes used interchangeably in this area, notably by the UK Financial Services Authority (FSA), the distinction can be mean- ingful: sect III below and ch 2.

2 It is not, accordingly, concerned with banking, insurance and pension-related services and products although, as discussed throughout the book, investment product innovation has placed considerable strains on the traditional regulatory segmentation between the banking, insurance and investment sectors.

3 Ch 2 considers ‘law in action’.

4 These include: FSA implementation of the behemoth Markets in Financial Instruments Directive regime (Directive 2004/39/EC of the European Parliament and of the Council of

21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, OJ 2004 No L145/1 (‘MiFID’)) and Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the Euro- pean Parliament and of the Council as regards organisational requirements and operating

1

drawing on international experience and experience in the other MemberStates.

Why consider the retail markets and retail market regulatory design?

As discussed in chapter 2, the financial crisis has wreaked destruction

on household market savings; it calls for careful consideration of therole of regulation in the retail markets But, before the financial crisis,the retail markets were worthy of close attention Greater responsibil-ity for financial planning and welfare provision, including with respect

to pension provision,5 is being imposed on individuals and householdsinternationally;6welfare is increasingly being privatized and governmentsare seeking stronger individual financial independence Risk is accord-ingly being transferred from government to households.7 Direct house-hold participation in the markets8is increasing;9IOSCO, for example, has

conditions for investment firms and defined terms for the purposes of that Directive, OJ

2006 No L241/26 (‘MiFID Level 2 Directive’) and the related extensive reforms to the FSA’s retail market conduct-of-business regime, in particular (chs 4 and 5); the FSA’s embrace

of a ‘more-principles-based’ regulation strategy (chs 2 and 4); continuing efforts on the pivotal ‘Key Features Document’ for retail investment products (ch 5); burgeoning finan- cial capability initiatives (ch 7); ever-deepening research efforts (ch 2); and radical and far-reaching reform of the investment product distribution and advice regime under the Retail Distribution Review (ch 4).

5 E.g S Benartzi and R Thaler, ‘Naive Diversification Strategies in Defined Contribution

Savings Plans’ (2001) 91 American Economic Review 79; and Ageing and Pension System

Reform: Implications for Financial Markets and Economic Policies (2005) (a report prepared at

the request of the Deputies of the G10 by an experts’ group chaired by I Visco, Banca d’Italia)

(‘G10 Report’), identifying the importance of savings products which are complementary

to pension products and which provide diversification (pp 15 and 17).

6 E.g C Borio, Change and Constancy in the Financial System: Implications for Financial

Distress and Policy (2007), ssrn abstractid=1022874 and European Commission, Minutes

of First Meeting of the Expert Group on Financial Education, 7 October 2008 The Dutch financial market regulator (the AFM), for example, has highlighted that more responsibility

is being placed on citizens and noted the ‘democratization’ of financial options: AFM, Policy

and Priorities for the 2007–2009 Period (2007), pp 11 and 12.

7 This point has been made in a range of studies E.g J Delmas-Marsalet, Report on the

Marketing of Financial Products for the French Government (2005) (‘Delmas Report’) and

Subgroup (of the Council of the EU’s Financial Services Committee) on the Implications of

ageing on financial markets, Interim Report to the FSC (FSC4180/06, 2006) (‘FSC Report’).

The rise in defined benefit schemes, for example, has been described as turning employees into investors and as underlining the importance of securities market regulation: M Condon,

‘Rethinking Enforcement and Litigation in Ontario Securities Regulation’ (2006) 32 Queen’s

house-highlighted increased levels of retail investor participation internationally

in collective investment schemes (CISs) and identified the securities kets as central to individual wealth.10And the financial markets have, as aresult, become significant politically.11

mar-In the UK, the retail investment markets have become the focus of closeregulatory and policy attention The FSA’s current attention to the effec-tiveness of investment advice ‘in action’ (chapter 4), for example, reflectsFSA concern to support effective investment advice and product distri-bution structures given government withdrawal from welfare provision,changing spending and saving behaviour, shifting employment patternsand other socio-economic factors which are placing pressure on long-term savings.12Its annual Financial Risk Outlooks repeatedly highlight theincreased pressure being placed on individuals and households to becomefinancially independent and the risks which arise from failure to do so.The 2005 Outlook, for example, identified increased longevity, health risks(including obesity risks), increased individual responsibility for financingeducation, changing patterns of employment (particularly an increase inpart-time and self-employed workers) and the need for long-term savings

in support of pension provision as significant trends that could (or should)influence individuals’ financial planning; it also highlighted the risks ofover-reliance on property investments.13In 2006, the FSA highlighted therisks posed by individuals’ failures to address pension provision as well asthe stresses placed on financial planning by, amongst other factors, lifestylechanges and child-care; similar concerns were highlighted in 2007.14Thechoices faced by individuals are also becoming increasingly complex asgovernments encourage market participation and as the industry reacts.Complex retail investment products are burgeoning,15as are government

North American Securities Administrators Association and FINRA, Protecting Senior

Investors: Compliance, Supervisory and other Practices Used by Financial Services Firms

in Serving Senior Investors (2008) (‘SEC Senior Report’), p 1 In the UK, three in eight

fami-lies (with a member between the ages of 50 and 64) hold some form of investment, whether

directly or through some form of wrapper: FSA, Asset Ownership, Portfolios and Retirement

Saving Arrangements: Past Trends and Prospects for the Future (Consumer Research No 74,

2008), p 1.

10IOSCO, Objectives and Principles of Securities Regulation (IOSCO, 2008), p 1.

11 Zingales has suggested that the massive increase in the use of financial markets for retirement

purposes has made them much more important politically: L Zingales, The Future of

Securities Regulation (2009), ssrn abstractid=1319648, p 2.

12FSA, A Review of Retail Distribution (Discussion Paper No 07/1, 2007) (‘2007 RDR’), p 17.

13FSA, Financial Risk Outlook 2005, pp 33–40 and 43.

14FSA, Financial Risk Outlook 2006, pp 71–4 and Financial Risk Outlook 2007, pp 77–82.

15 See further ch 3.

initiatives to encourage long-term and market-based savings; the UK ChildTrust Fund, for example, provides some limited exposure to the markets.16The need for stronger financial independence, and for effective andresponsive retail markets, has been repeatedly highlighted by the Com-munity institutions Political direction has come from the Council ofthe European Union, which has called on governments to strengthen thetools with which they monitor household savings and to increase theirefforts to raise households’ awareness of financial education and informa-tion needs.17 The Council’s powerful Financial Services Committee hasengaged in a wide-ranging review of the implications of ageing populationsfor financial markets, highlighting the macro-economic and demographictrends which are leading to pressure on households to increase market-based savings;18 while governments and financial institutions (such aspension funds) have traditionally intermediated the risks of market invest-ment, the Committee reported that they are now increasingly being carrieddirectly by households.19The European Parliament, often sceptical of thefinancial markets, has acknowledged that societal and lifestyle changesdemand sound management of private finances and has related betterfinancial literacy to lower levels of problem debt, increased savings andadequate retirement provision.20 A similar concern has come from theCommunity’s executive, the European Commission In its 2007 GreenPaper on Retail Financial Services it argued that ageing populations andincreasing pressure on public finances presented ‘clear challenges for con-sumers and investors’ and highlighted the need for a ‘competitive, openand effective market for long-term savings’.21Earlier, its 2005 White Paper

on Financial Services called for a boost in the efficiency of pan-Europeanmarkets for long-term savings products.22 The need for regulatory pol-icy to support long-term savings through the markets has also emerged

16 See further ch 2.

17 ECOFIN Conclusions, 2798th Meeting, 8 May 2007, Press Release, pp 10–11.

18FSC Report The dependency ratio (or the proportion of the population aged over 65 as a

proportion of the population aged 15–64) is expected to increase from 24 per cent in 2003

to 51 per cent in 2050 (p 5) and substantial strain is accordingly expected on public pension schemes (pp 5–10) The Report suggested that higher levels of savings may be required following changes to pension provision and to medical subsidies but that ‘investment in riskier assets’ may reduce the need for additional savings (p 11).

19Ibid., pp 14–16.

20European Parliament, Resolution on Improving Consumer Education and Awareness on

Credit and Finance (P6–TA(2008)0539, 2008), paras A and B.

21European Commission, Green Paper on Retail Financial Services in the Single Market (COM

(2007) 226), p 11.

22European Commission, White Paper on Financial Services (2005–2010) (COM (2005) 629),

p 4.

as a marked theme of the current debate on the treatment of substituteinvestment products.23

Regulators internationally are also increasingly addressing the risksfaced by older and retired investors The FSA has reviewed how the finan-cial services market operates for older consumers and highlighted poorunderstanding of retirement and associated products and services anddifficulties with access to advice;24 it has also underlined the particularvulnerability of older investors to share scams.25 Internationally, the USSecurities and Exchange Commission (SEC) has also focused closely on theprotection of ‘senior investors’, adopting investor education programmes,highlighting and prosecuting frauds and scams to which senior investorsmay be vulnerable, and providing guidance to financial services firms.26

In this environment, the resilience of investor protection and the priateness of efforts to promote individual engagement with the marketsbecome of central importance

appro-II The retail markets and the EC

1 The development of a retail market agenda

a) Early developments

In pursuit of the EC Treaty objective of securing an internal market(Articles 3 and 14 EC) and in support of the Treaty free movementguarantees,27 the Community institutions have long been engaged inthe construction of an integrated financial market within which mar-ket actors can freely access liberalized cross-border markets.28 Financialmarket integration is presumed to generate significant benefits in terms

of choice, competition and easier access to capital and, ultimately, more

23 The Commission, for example, has acknowledged that the policy debate ‘assumes added importance’ given the need to create the right conditions to support market-driven

solutions for private retirement provisioning: European Commission, Call for Evidence:

Need for a Coherent Approach to Product Transparency and Distribution Requirements for

‘Substitutive’ Retail Investment Products (2007), p 21.

24FSA, Finance in and at Retirement – Results of Our Review (2007) Although the FSA did

not find market failures, it highlighted difficulties concerning access to advice as well as widespread poor understanding of retirement and associated products and services.

25 FSA, Press Release, 27 April 2009 (FSA/PN/055/2009) 26SEC Senior Report.

27 Particularly the freedom to provide services (Art 49 EC), the freedom to establish (Art 43 EC) and the free movement of capital (Art 56 EC) Treaty references are to the EC Treaty,

as the Treaty on the Functioning of the EU had not come into force at the time of writing (see Preface and acknowledgments).

28N Moloney, EC Securities Regulation (2nd edn, Oxford: Oxford University Press, 2008),

ch 1.

liquid and efficient markets and stronger economic growth.29The legaltechnology used to achieve market integration30has been based on, first,the liberalization of market access through de-regulation (or the removal

of Member States’ ability to impose local regulatory requirements oncross-border actors) and, secondly, on the related re-regulation of thosemarkets by a common harmonized rule base Liberalization is achieved

by the requirement for Member States to accept, or mutually recognize,the regulation (and often supervision) of cross-border actors by thoseactors’ home Member States (typically the State where the actor has itshead office); mutual recognition is supported by re-regulation or the har-monization of Member States’ rules in order to remove the integrationobstacles which protectionist or, more usually, diverging local rules repre-sent, and to allow mutual trust between regulatory regimes As part of thisprocess of de-regulation, liberalization and re-regulation, the regulation

of domestic financial markets has, over time, moved from the MemberStates to the EC and become a function of harmonized rules But theCommunity’s embrace of retail investor protection regulation and policy

is a relatively recent phenomenon

The seminal 1966 Segr´e Report, the opening salvo in what has sincebecome a massive harmonized regulatory programme for financial ser-vices and markets, did not address retail investor protection in any detail.31The early phases of EC financial market regulation (from the late 1970s)were concerned with supply-side market access Integration was initiallysought through, first, detailed rule harmonization (best exemplified by theearly securities directives (now repealed) which addressed capital-raising,disclosure and issuer access to cross-border markets) and, secondly, inthe wake of the 1985 Commission White Paper on the Internal Market,32minimum harmonization (which allowed Member States to impose morestringent rules on their domestic actors and so accommodated some degree

29E.g London Economics, Quantification of the Macro-Economic Impact of Integration of EU

Financial Markets: Final Report to the European Commission (2002).

30 Whether or not law can drive market integration and change actors’ behaviour is a very

large question On the debate, see further Moloney, EC Securities Regulation, pp 40–7 and,

in the retail context, sect II.3 below and ch 2.

31 Perhaps because at that time ‘in continental Europe stockbrokers and other dealers are not organized in such a way as to facilitate contacts with the public at large As for investment consultants, they are still far removed from the developed stage they have attained on the capital markets of some non-member countries’: Report by a Group of Experts Appointed

by the EEC Commission, The Development of a European Capital Market (1966) (‘Segr´e

Report’), p 204.

32European Commission, Completing the Internal Market (COM (85) 310).

of regulatory competition) and mutual recognition (best exemplified bythe 1985 UCITS Directive33 on the UCITS CIS and the now-repealed

1993 Investment Services Directive (ISD) on investment services34) TheISD asserted in a recital reference that one of its objectives was to protectinvestors But this assertion sat very uneasily in a Directive which was pri-marily focused on the investment firm, on the investment services passportand on achieving the minimum level of harmonization required to supporthome Member State control of cross-border investment firm activity ISDharmonization was primarily directed to prudential and stability require-ments; marketing and conduct-of-business regulation, touchstones forinvestor protection in the intermediation context, were not harmonizedand were thus left to the control of host Member States

The first significant moves towards a harmonized investor protectionregime came in the late 1990s when market integration became moreclosely associated with the demand-side, the support of investor con-fidence as a means of encouraging integration35 and, accordingly, theharmonization of investor protection rules The first hint of an investor-facing approach came in 1996 when the Commission presented its GreenPaper on Financial Services Consumers36which highlighted a number ofinvestor protection concerns including aggressive marketing by invest-ment firms and poor disclosure A separate development outside thefinancial market policy sphere, the adoption of the 2000 E-CommerceDirective,37further sharpened the focus on investor protection The Direc-tive anchored cross-border e-commerce/online services (including onlineinvestment services) to the ‘Member State of origin’ (essentially the State

of establishment) and removed the ability of host Member States to applytheir protective rules to cross-border online services The Directive’s strik-ing innovation was to remove host State control without parallel ruleharmonization By such accidents, or at least by a lack of joined-up

33 Council Directive 85/611/EEC of 20 December 1985 on the co-ordination of laws, tions and administration provisions relating to undertakings for collective investment in transferable securities, OJ 1985 No L375/3.

regula-34 Council Directive 93/22/EEC of 10 May 1993 on investment services in the securities field,

OJ 1993 No L141/27.

35 N Moloney, ‘Confidence and Competence: The Conundrum of EC Capital Markets Law’

(2004) 4 Journal of Corporate Law Studies 1.

36European Commission, Green Paper on Financial Services: Meeting Consumers’ Expectations

(COM (96) 209).

37 European Parliament and Council Directive 2000/31/EC of 8 June 2000 on certain legal aspects of information society services, in particular electronic commerce, in the single market, OJ 2000 No L178/1.

thinking across different Commission divisions, do major shifts in tory design occur The subsequent 2001 Communication on E-Commerceand Financial Services38called for further convergence of protective rules,including conduct-of-business rules, in order to address the danger thatMember States would rely on the E-Commerce Directive’s derogations tothe Member-State-of-origin principle to protect investors and consumerswhere the Member State of origin’s rules were not regarded as offeringadequate protection But the Communication also adopted an investor-facing agenda It linked market integration to the demand side and notedthat ‘consumer confidence’ depended on sufficiently harmonized levels

regula-of protection An initial response came in the form regula-of the 2002 DistanceMarketing of Financial Services Directive (DMD),39which addresses dis-closure, marketing, contractual rights (including withdrawal rights) andredress in the distance marketing context and which applies to a range

of financial services, including investment services It was the EC’s firstsustained attempt to grapple with investor protection It also reinforcedthe emerging reliance on ‘confidence’ as a demand-side justification forharmonization and market-integration measures; it argued that a highdegree of consumer protection was required to enhance consumer con-fidence in distance selling (recital 3), and that a high level of consumerprotection should be guaranteed by the Directive (recital 13)

b) The FSAP and the retail interestBefore the pivotal 1999 Financial Services Action Plan (FSAP),40a mas-sive regulatory agenda which was designed to complete the integration

of financial markets and remedy years of slow development, had begun

to gather steam, the establishment of the Lamfalussy structures for EClaw-making in the financial market sphere brought another influence tobear on the developing retail market agenda The seminal 2001 LamfalussyReport41was concerned with the establishment of a new EC law-makingmechanism for delegated law-making (which empowers the Commission

38European Commission, Communication on E-Commerce and Financial Services (COM

(2001) 66).

39 European Parliament and Council Directive 2002/65/EC of 23 September 2002 ing the distance marketing of consumer financial services and amending Council Direc- tive 90/619/EEC and Directives 97/7/EC and 98/27/EC, OJ 2002 No L271/16 (‘Distance Marketing Directive’ or DMD).

concern-40European Commission, Communication on Implementing the Framework for Financial

Markets: Action Plan (COM (1999) 232) (FSAP).

41Final Report of the Committee of Wise Men on the Regulation of European Securities Markets

(2001) (‘Lamfalussy Report’).

to adopt delegated rules, advised by the Committee of European SecuritiesRegulators (CESR, composed of Member State regulators) and supervised

by the European Securities Committee (ESC, composed of Member Staterepresentatives)).42Financial market rules now take the form of ‘level 1’measures (typically directives) adopted by the institutions under tradi-tional Treaty law-making procedures, detailed ‘level 2’ rules adopted bythe Commission and ‘level 3’ guidance adopted by CESR.43But the Lam-falussy Report also prioritized retail investor protection It highlightedthe absence of ‘high and equivalent levels of consumer protection and

no efficient methods for resolving cross-border consumer disputes’ andrecommended that ‘the conceptual framework of overarching principles’,

on which, it suggested, all EC financial market regulation should be based,include a commitment to ensuring ‘appropriate levels of consumer pro-tection proportionate to the different degrees of risk involved’.44Its lastinglegacy to the retail market agenda, however, was the establishment of CESR,which has had a far-reaching influence on the EC retail market agenda.45The explosive combination of the Lamfalussy law-making reforms andthe FSAP regulatory reform agenda led to an exponential increase inthe intensity of EC financial market regulation over the FSAP period(1999–2004) The FSAP also included a discrete retail market agenda46andthe retail market interest emerged strongly across a series of FSAP mea-sures The first indications of the adoption of a retail market agenda camewith the 2003 Prospectus Directive.47 While designed to support cross-border capital-raising by issuers (by harmonizing prospectus requirementsand clarifying the scope of private placements), it is also designed tobuild the confidence of ‘small investors’ in financial markets (recital 41)and has a strong retail orientation;48 recital 16 states that ‘one of theobjectives of this Directive is to protect investors’.49 The most dramatic

42 See further ch 7 43Ibid.

44Lamfalussy Report, pp 12 and 22. 45 See further ch 7.

46 ‘Appropriate and progressive harmonization of marketing and information rules out the Union together with a pragmatic search for non-legislative solutions offers the prospect of a truly integrated retail market fully respecting the interests of consumers and suppliers’: FSAP, p 10.

through-47 Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003

on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC, OJ 2003 No L345/64 (‘Prospectus Directive’).

48 The European Commission’s advisory European Securities Market Expert Group has described the principal objective of the Prospectus Directive as to protect the retail investor:

ESME, Report on Directive 2003/71 (2007), p 10 See further ch 6.

49 But investor protection runs across the Directive E.g recitals 10, 18, 19, 20 and 21.

developments, however, occurred with MiFID.50 The massive MiFIDregime, discussed throughout this book, is expressly designed to supportinvestor protection (e.g recital 31)51 and addresses conduct-of-businessregulation (including marketing, disclosure and suitability requirements),best execution, conflict-of-interest management and order execution andmarket transparency MiFID is also notable for the Commission’s relatedregulatory rhetoric which claims investor protection (domestically andcross-border) as a legitimate concern of EC financial market regulation52and which appears to break the link between investor-protection-basedharmonization and market integration;53under MiFID, investor protec-tion has become an end in itself The MiFID Proposal was designed toaddress the failure of the precursor ISD to provide a ‘bedrock of harmo-nized investor protection’,54while the pivotal conduct-of-business regimewas described as a ‘mainstay of investor protection’.55In one of the morestriking of MiFID’s many retail market innovations, the regulation ofinvestment advice has now become a function of EC law (chapter 4) But

50 It has been described as ‘the most significant directive in capital markets law of recent

times’: BaFIN, Annual Report 2007–2008, p 12.

51 The FSA has described MiFID in investor protection terms: ‘One of the main objectives

of MiFID is to provide a high level of investor protection’: Reforming Conduct of Business

Regulation (Consultation Paper No 06/19, 2006), p 9.

52 ‘There is a need for enlightened regulation to define the rules of the game and for strong policemen to enforce these rules [MiFID] should equip regulators with a comprehensive set of regulatory disciplines to tackle the risks to which the modern retail investor is

exposed A high level of protection is crucial in its own right [emphasis added] It is

also a pre-condition for the effective operation of the ISD passport’: Speech by General Schaub of the Internal Market Directorate General on ‘Economic and Regulatory Background to the Commission Proposal for Revision of the ISD’, 15 October 2002, available via http://europa.eu/rapid/searchAction.do.

Director-53 All EC legislative measures must meet subsidiarity and proportionality requirements and be based on a Treaty competence (Art 5 EC) In the financial markets sphere, harmonization has typically been based in the free-movement- and barrier-removal-related competences set out in Art 44(2)(g) EC (directives designed to co-ordinate the safeguards required by Member States of companies or firms for the protection of members and others), Art 47(2) EC and Art 55 EC (directives designed to co-ordinate Member States’ rules on the taking up and pursuit of activities as self-employed persons) and in the two general single market competences, Art 94 EC (directives for the approximation of Member States’ rules which directly affect the establishment or functioning of the common market) and Art 95

EC (measures for the approximation of Member States’ rules which have as their object the establishment and functioning of the internal market) The EC institutions do not enjoy a general power to regulate the internal market Internal market measures must be based on the need to remove regulatory barriers or distortions to competition, although the Commission has rarely appeared troubled by this restriction: Moloney, ‘Confidence and Competence’.

54European Commission, MiFID Proposal (COM (2002) 625), p 23. 55Ibid., p 25.

investor protection, not market integration, is the concern; recital 3 doesnot justify the inclusion of advice by reference to the integration of theadvice industry It notes instead that ‘due to the increasing dependence

of investors on personal recommendations’ it was appropriate to includeinvestment advice as a service requiring authorization On its application

on the markets in November 2007 the Commission greeted MiFID as arobust and comprehensive framework for ensuring high levels of investorprotection.56The investor protection rhetoric has also been taken up byCESR which described the harmonization of ‘investor protection through-out Europe and increase[ing] consumers’ confidence that the productsthey are being sold are actually appropriate for their needs’ as ‘one of themain purposes’ of MiFID.57

c) Post-FSAPPost-FSAP, the policy focus on the retail markets has continued Inte-gration has often been a subsidiary concern in this period which hasseen a focus on effective regulatory design for the retail markets In theUCITS investment products sphere,58 for example, radical reforms tothe design of UCITS disclosure are taking place; the EC is also grap-pling with the difficulties raised by substitute investment products andthe retailization of alternative investments.59This period is also stronglyassociated with a more holistic appreciation of retail market policy andwith a concern to promote financial literacy, stronger retail involvement

in the law-making process and access to redress.60Belated efforts are alsobeing made to understand retail investor behaviour, with the publication

of important reports on long-term retail saving patterns61 and on retailmarket disclosures.62

The Commission’s 2007 Green Paper on Retail Financial Services63points to the entrenchment of the retail market agenda Its earlier 2005

56 European Commission, Press Release, IP/07/1625.

57 Press Release Accompanying the Retail Investor Guide to MiFID (CESR/08-209, 2008),

p 1.

58 The EC’s collective investment regime focuses on the UCITS product.

59 Chs 3 and 5 60 Chs 7 and 8.

61BME Consulting, The EU Market for Consumer Long-Term Retail Savings Vehicles:

Com-parative Analysis of Products, Market Structure, Costs, Distribution Systems, and Consumer Savings Patterns (2007) (‘BME Report’).

62Optem, Pre-contractual Information for Financial Services: Qualitative Study in the 27

Mem-ber States (2008) (‘Optem Report’).

63European Commission, Green Paper on Retail Financial Services.

White Paper on Financial Services Policy had identified the retail market

as a key element of the 2005–10 financial services agenda and committed

to a series of investor-facing initiatives, including with respect to investoreducation initiatives, investor governance and redress.64The 2007 GreenPaper was concerned with ensuring that the integrated financial servicesmarket (including investment services) delivered products that met con-sumer needs, enhancing consumer confidence by ensuring consumerswere properly protected and empowering consumers to take the rightdecisions.65 Retail financial services markets (including investment ser-vices) were also a theme of the Commission’s wider 2007 internal marketpolicy initiative which addressed the distribution of investment products,financial education and redress.66By late 2007, the retail interest in finan-cial services generally had become a major policy priority.67 The shift

in emphasis is well illustrated by the minutes of the Commission’s thennewly constituted consultative Financial Services Consumer Group which,

in December 2007, noted that transparency, the provision of informationand education were all key elements of the current policy debate.68None

of these elements was a feature of the EC policy debate prior to the FSAP.Why did retail investor protection acquire such prominence, partic-ularly given the absence of retail stakeholders from the policy debate(chapter 7)? Traditional integration concerns are certainly a factor, as

is the internal momentum which the FSAP and the Lamfalussy modelgenerated.69 But regulatory empire-building by the Commission, theengine of policy development in the EC, cannot be discounted giventhe political power of the retail market agenda and its association withregulation Member States have become increasingly willing to devolveretail market regulation to the EC (section II.2.c below) And, perhapsabove all, the Commission has embraced the investor empowerment and

‘marketing the markets’ agenda which is becoming associated with retailinvestor policy internationally (chapter 2)

64European Commission, White Paper on Financial Services, pp 7–8.

65European Commission, Green Paper on Retail Financial Services, pp 2–3.

66European Commission, A Single Market for 21st Century Europe (COM (2007) 725), Staff

Working Paper on Initiatives in the Area of Retail Financial Services.

67 The Commission argued that ‘consumer information and protection are at the heart of EU

financial services legislation’: European Commission, Communication from the

Commis-sion, Financial Education (2007), p 1.

68 Financial Services Consumer Group, Minutes, 12 December 2007.

69See further Moloney, EC Securities Regulation, pp 19–22.