Sapienza Università di Roma International Banking Lecture eight The Markets in Financial Instruments Directive & Sarbanes–Oxley Act Prof. G. Vento

Sapienza Università di Roma

International Banking

Lecture eight

The Markets in Financial Instruments Directive & Sarbanes–Oxley Act

Prof. G. Vento

Agenda

1. The MiFID2. Core principles of the directive3. Key impacts of MiFID4. Conclusions: main changes5. The Sarbanes–Oxley Act

March 2013 Int. nal Banking - Prof. G. Vento 2

1. The Markets in Financial Instruments Directive (MiFID)

• The Markets in Financial Instruments Directive (MiFID) as subsequently amended is a European Union law which provides a harmonised regulatory regime for investment services across the 30 member states of the European Economic Area (the 27 Member States of the European Union plus Iceland, Norway and Liechtenstein).

• The main objectives of the Directive are to increase competition and consumer protection in investment services. As of the effective date, 1 November 2007, it replaced the Investment Services Directive.

• MiFID is the cornerstone of the European Commission's Financial Services Action Plan whose 42 measures will significantly change how EU financial service markets operate.


1. Key issues on MiFID• MiFID retained the principles of the EU 'passport'

introduced by the Investment Services Directive (ISD) but introduced the concept of 'maximum harmonization' which places more emphasis on home state supervision.

• This is a change from the prior EU financial service legislation which featured a 'minimum harmonization and mutual recognition' concept.

• Another change was the abolition of the 'concentration rule' in which member states could require investment firms to route client orders through regulated markets.


1. The MiFID Structure• The MiFID is composed of a level 1 text that serves

as a superstructure setting out the core principles of legislation, while the more detailed provisions are set out in level 2 texts, so called implementing measures.

• The implementing directive covers issues that are essentially applicable to investment firms, especially conduct-of-business rules such as: exercising due diligence in selling services to retail clients, best execution, safeguard client assets, conflict of interest.

• The implementing regulation covers the area of pre- and post-trade transparency, as well as record keeping and transaction reporting.


1. Scope of MiFID• In order to determine which firms are affected by MiFID and

which are not, MiFID distinguishes between "investment services and activities" ("core" services) and "ancillary services" ("non-core" services).

• If a firm performs investment services and activities, it is subject to MiFID in respect both of these and also of ancillary services (and it can use the MiFID passport to provide them to member states other than its home state). However if a firm only performs ancillary services, it is not subject to MiFID (but nor can it benefit from the MiFID passport).

• Under MiFID, a study estimates that the three largest EU jurisdictions (France, Germany, and the UK) will surface over 100 million additional trades annually.


1. A comparison with Investment Services Directive

• MiFID is more onerous and detailed than its predecessor

• It is the price to pay for wanting to create a level playing field through the implementation of statutory rules rather than through the establishment of common principles

• The more level playing field introduced by MiFID means that large investment firms with operations in several member state no longer need to comply with a panoply of different conduct-of-business rules


2. Key aspects of MiFID: Authorisation, regulation

and passporting • Firms covered by MiFID will be authorised and

regulated in their "home state" (broadly, the country in which they have their registered office).

• Once a firm has been authorised, it will be able to use the MiFID passport to provide services to customers in other EU member states.

• These services will be regulated by the member state in their "home state" (whereas currently under ISD, a service is regulated by the member state in which the service takes place).


2. Key aspects of MiFID: Client categorisation • MiFID requires firms to categorise clients as "eligible

counterparties", professional clients or retail clients (these have increasing levels of protection).

• Clear procedures must be in place to categorise clients and assess their suitability for each type of investment product.

• That said, the appropriateness of any investment advice or suggested financial transaction must still be verified before being given.


2. Key aspects of MiFID: Client order handling

• MiFID has requirements relating to the information that needs to be captured when accepting client orders, ensuring that a firm is acting in a client's best interests and as to how orders from different clients may be aggregated.


2. Key aspects of MiFID: Pre-trade transparency

• MiFID will require that operators of continuous order-matching systems must make aggregated order information on "liquid shares" available at the five best price levels on the buy and sell side.

• For quote-driven markets, the best bids and offers of market makers must be made available.


2. Key aspects of MiFID: Post-trade transparency

• MiFID will require firms to publish the price, volume and time of all trades in listed shares, even if executed outside of a regulated market, unless certain requirements are met to allow for deferred publication.


2. Key aspects of MiFID: Best execution • MiFID will require that firms take all reasonable steps to

obtain the best possible result in the execution of an order for a client.

• The best possible result is not limited to execution price but also includes cost, speed, likelihood of execution and likelihood of settlement and any other factors deemed relevant.

• Provisions on best execution are part of conduct-of-business rules and aim to maximise the value of a client’s portfolio, in the context of the client’s stated investment objectives and constraints

• This does not necessary mean the lowest price of a trade.


2. Suitability• Investment firms ensure that the products being

marketed to retail investors correspond to their levels of financial education and wealth

• The MiFID adopts detailed provisions on the exercise of due diligence by investment firms in the recommendation and sale of products and services to non-professional clients

• If retail clients fail to provide such documentation on request, an investment firm may feel uneasy about providing them with anything but the most basic, low-yield products


2. Price transparency

• Under the new regime investment firms and banks will be allowed to create a market for shares by trading on own account.

• Generally speaking, the ISD did not allow transaction to take place outside the exchange, or regulated market.

• The MiFID abolished the concentration provision.


3. Key Impacts of MiFID 1/2

• MiFID will accelerate some important ongoing changes in European financial markets that are driven primarily by technological improvements and enhanced competition in the provision of financial services arising from globalisation

• MiFID directly touches four distinct groups of actors within the financial services industry: investment firms (which may have fairly different organisational models across countries), exchange and quasi-exchange (multilateral trading facilities), data vendors and specialised IT firms and solution providers.


3. Key impacts of MiFID 2/2

1. As a result of high compliance costs and greater operational complexity, MiFID will lead to a further consolidation phase in the brokerage industry

2. Exchanges are expected to remain the main source of liquidity and price formation for the time being, but they will be subject to more competition in their trade reporting and settlement activities

3. OTC markets are going to be more heavily regulated than in the past under MiFID.

4. A significant rise in algorithmic trading is almost a certainty.5. Trading volumes should increase as a result of greater

competition.6. A massive market for market data will arise out of MiFID.


3. MiFID contradiction• Although MiFID was intended to increase transparency for

prices, in fact the fragmentation of trading venues has had an unanticipated effect.

• Where once a financial institution was able to see information from just one or two exchanges, they now have the possibility (and in some cases the obligation) to collect information from a multitude of multilateral trading facilities, and other exchanges from around the European Economic Area.

• This results in an additional amount of work to benefit from the transparency that MiFID has introduced.


3. Dealing with Fragmentation

• The number of additional pricing sources introduced by MiFID means that Financial institutions have had to seek additional data sources to ensure that they capture as many quotes/trades as possible.

• Numerous Financial data vendors have worked with the MiFID Joint Working Group and Regulators to make sure that they are able to help financial institutions to deal with the fragmentation and benefit from the increased transparency, while helping them to fulfil their new reporting liabilities.


4. Conclusions: main changes• The harmonisation of conduct of business rules for securities trading,

including strict rules on best execution of trades, client categorisation and client reporting

• Rules on internal governance of investment firms, requiring them to tackle conflict of interest, maintain good governance and ensure continuity of their services

• The abolition of the concentration rules of the ISD, by which member states could require trades to be executed on the main exchange or on the regulated market

• The much greater possibility for investment firms to internalise trades• The European passport for Multilateral Trading Facilities, which can be

created by investment firms and exchanges• The extension of the single passport regime to some other services

(i.e. investment advice) and some other markets (commodities, more derivatives).


The Sarbanes–Oxley Act


5. The Sarbanes–Oxley Act • The Sarbanes–Oxley Act of 2002, also known as the 'Public

Company Accounting Reform and Investor Protection Act‘, is a United States federal law enacted on July 30, 2002.

• The bill was enacted as a reaction to a number of major corporate and accounting scandals including those affecting Enron and WorldCom.

• The legislation set new or enhanced standards for all U.S. public company boards, management and public accounting firms.

• Sarbanes–Oxley contains 11 titles that describe specific mandates and requirements for financial reporting.


5. The Sarbanes–Oxley Act: title 1 Public Company Accounting Oversight Board

• Public Company Accounting Oversight Board, to provide independent oversight of public accounting firms providing audit services ("auditors").

• It also creates a central oversight board tasked with registering auditors, defining the specific processes and procedures for compliance audits, inspecting and policing conduct and quality control, and enforcing compliance with the specific mandates of SOX.


5. The Sarbanes–Oxley Act: title 2 Auditor Independence

• Title II establishes standards for external auditor independence, to limit conflicts of interest.

• It also addresses new auditor approval requirements, audit partner rotation, and auditor reporting requirements. It restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients.


5. The Sarbanes–Oxley Act: title 3 Corporate responsability

• Title III mandates that senior executives take individual responsibility for the accuracy and completeness of corporate financial reports.

• It defines the interaction of external auditors and corporate audit committees, and specifies the responsibility of corporate officers for the accuracy and validity of corporate financial reports.

• It enumerates specific limits on the behaviors of corporate officers and describes specific forfeitures of benefits and civil penalties for non-compliance.

• For example, Section 302 requires that the company's "principal officers" (typically the Chief Executive Officer and Chief Financial Officer) certify and approve the integrity of their company financial reports quarterly


5. The Sarbanes–Oxley Act: title 4 Enhanced Financial Disclosures

• Title IV describes enhanced reporting requirements for financial transactions, including off-balance-sheet transactions, pro-forma figures and stock transactions of corporate officers.

• It requires internal controls for assuring the accuracy of financial reports and disclosures, and mandates both audits and reports on those controls.

• It also requires timely reporting of material changes in financial condition and specific enhanced reviews by the SEC or its agents of corporate reports.


5. The Sarbanes–Oxley Act: title 5 Analyst Conflicts of Interest

• Title V includes measures designed to help restore investor confidence in the reporting of securities analysts.

• It defines the codes of conduct for securities analysts and requires disclosure of knowable conflicts of interest.


5. The Sarbanes–Oxley Act: title 6 Commission Resources and Authority

• Title VI defines practices to restore investor confidence in securities analysts.

• It also defines the SEC’s authority to censure or bar securities professionals from practice and defines conditions under which a person can be barred from practicing as a broker, advisor, or dealer.


5. The Sarbanes–Oxley Act: title 7 Studies and Reports

• Title VII requires the Comptroller General and the SEC to perform various studies and report their findings.

• Studies and reports include the effects of consolidation of public accounting firms, the role of credit rating agencies in the operation of securities markets, securities violations and enforcement actions, and whether investment banks assisted Enron, Global Crossing and others to manipulate earnings and obfuscate true financial conditions.


5. The Sarbanes–Oxley Act: title 8 Corporate and

Criminal Fraud Accountability

• Title VIII is also referred to as the “Corporate and Criminal Fraud Act of 2002”.

• It describes specific criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations, while providing certain protections for whistle-blowers.


5. The Sarbanes–Oxley Act: title 9 White Collar Crime Penalty Enhancement

• Title IX is also called the “White Collar Crime Penalty Enhancement Act of 2002.” This section increases the criminal penalties associated with white-collar crimes and conspiracies.

• It recommends stronger sentencing guidelines and specifically adds failure to certify corporate financial reports as a criminal offense.


5. The Sarbanes–Oxley Act: title 10 Corporate Tax Returns

• Title X states that the Chief Executive Officer should sign the company tax return.


5. The Sarbanes–Oxley Act: title 11 Corporate Tax Returns

• Title XI recommends a name for this title as “Corporate Fraud Accountability Act of 2002”. It identifies corporate fraud and records tampering as criminal offenses and joins those offenses to specific penalties.

• It also revises sentencing guidelines and strengthens their penalties. This enables the SEC the resort to temporarily freeze transactions or payments that have been deemed "large" or "unusual".


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Sapienza Università di Roma International Banking Lecture eight The Markets in Financial Instruments Directive & Sarbanes–Oxley Act Prof. G. Vento