EN

(...PICT...)|COMMISSION OF THE EUROPEAN COMMUNITIES|

Brussels, 30.4.2009

SEC(2009) 556

COMMISSION STAFF WORKING DOCUMENT

Accompanying the COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL PACKAGED RETAIL INVESTMENT PRODUCTS IMPACT ASSESSMENT {COM(2009) 204} {SEC(2009) 557}

TABLE OF CONTENTS

1. Introduction 6

2. Procedural Issues 7

3. Problem definition 8

3.1. Market context and problem drivers 8

3.2. Problem description 11

3.2.1. Risks of investor detriment 12

3.2.1.1. Inadequate pre-contractual product disclosures and marketing rules 13

3.2.1.2. Inadequate care or professionalism in the selling process 17

3.2.2. Competitive distortions resulting from an 'unlevel playing field' between product types and distribution channels 18

3.2.3. Divergent national responses: impact on single market 20

3.3. How would the problem evolve without further action? 22

4. Subsidiarity and Legal Basis 23

5. Objectives 23

5.1. A high and consistent level of investor protection 24

5.2. A level playing field for the originators and distributors of packaged retail investment products 25

5.3. Increased efficiency in cross-border business 25

6. Options 26

6.1. Pre-contractual product disclosures 26

6.1.1. Identification of options 26

6.1.2. Analysis of costs and benefits 28

6.2. Selling practices 31

6.2.1. Identification of options 31

6.2.2. Analysis of costs and benefits 32

6.3. Comparison of high-level assessment of options 33

6.3.1. Pre-contractual information 33

6.3.2. Selling practices 34

6.3.3. Identifying the preferred options 34

7. Impacts on various stakeholders' groups, employment, SMEs, environment and third countries 35

7.1. Stakeholders 35

7.2. Employment 36

7.3. SMEs 36

7.4. Environment and third countries 37

7.5. Administrative burden 37

7.6. Monitoring and evaluation 38

8. Conclusions 39

ANNEX 1 40

1. List of Acronyms 40

2. Problem tree 41

3. What are packaged 'retail investment products'? 42

4. How big is the market for packaged retail investment products? 43

5. How are packaged retail investment products distributed? 43

6. Member State approaches to the regulation of retail investment products. 45

7. European disclosure and distribution rules for retail investment products 47

7.1. Pre-contractual product disclosures 47

7.2. Conduct of business rules 49

7.3. Conflicts of interest and inducement rules 50

7.4. Marketing and advertising rules 52

7.5. E-Commerce Directive and Distance Marketing of Financial Services Directive 54

ANNEX 2 56

1. Detailed analysis of high-level options for Pre-contractual Disclosures 56

1.1. Analysis of options 56

1.1.1. Commission sponsored self-regulation 56

1.1.2. Mandate to Level 3 committees to promote supervisory convergence 58

1.1.3. Commission Recommendation to implement principles through national regulation 60

1.1.4. EU-level legislative action 62

2. Detailed analysis of high-level options for Selling Processes 64

2.1. Analysis of options 64

2.1.1. Commission sponsored self regulation 64

2.1.2. Mandate to Level 3 committees to promote supervisory convergence 66

2.1.3. Commission Recommendation to implement principles through national regulation 67

2.1.4. EU-level legislative action 68

1. Introduction

The financial crisis has provided a stark reminder of the importance of transparency in financial products and of responsible selling in institutional and retail sectors. Investors naturally carry some market risk when making investments, so that exposure to weak or negative returns in adverse market conditions, while clearly detrimental to the investor, is a natural corollary of the investors' acceptance of market risk. This risk is, effectively, the price that needs to be paid to gain the potential for greater performance. The financial crisis, however, has underlined the extent to which the scale and nature of the risk taken on by investors may not be as evident to them as it should be. There has been a collapse in investor confidence in financial products and the markets more generally, and this can in part be linked to misplaced investor expectations, for instance where products have unexpectedly underperformed or where guaranteed products have, for various reasons, failed to protect capital. As a result, transparent products that are clearly explained and fairly sold to investors have a vital role to play in restoring investor confidence and promoting effective retail engagement with the financial markets.

Throughout the European Union, a range of 'packaged' investment products are actively marketed to retail investors. These products offer the prospect of financial returns over the medium to long term, based on a combination of exposures to financial markets. Up to €10 trillion were invested by the end of 2007 through different types of retail investment product, such as investment funds, structured securities, unit-linked life insurance policies and structured term deposits. These products take distinct legal forms but perform comparable economic functions for retail investors. In a well-functioning market, competition between families of retail investment product offers the prospect of an efficient allocation of resources, by creating incentives for producers to capture market share by developing and selling products that provide a good match for the profiles of prospective investors.

The markets for these products are however characterised by certain failings, notably steep asymmetries in information between product originators and distributors on the one hand and end clients on the other, and principle-agent issues resulting in conflicts of interest for distributors. Unchecked, these market failures may give rise to investor detriment, for example, as a result of product mis-selling or simply through poor decision-making due to insufficient information about the key features of the products on offer.

Public authorities have sought to mitigate these failings: by promoting financial education; through the regulation of products and the institutions that originate and distribute them; through requirements on the provision of product information; and by regulating the process by which products are sold or advised upon. Rules have been developed which seek to ensure that prospective clients receive product information pre-contractually so as to enable effective decision-making; and that the distributors and originators of investment products conduct their business fairly and objectively and do not put their interests before those of the client.

However, the rules on product disclosure and selling practices that have evolved at the European level have done so on a largely sectoral basis. Consequently, the applicable rules vary according to the legal form of the product and the legal status of the intermediary selling the product. In some sectors and for some products, there are no applicable rules at European level.

These variations and gaps have provoked widespread concern that approaches in Community law are not coherent and that, despite remedial action taken at national level in some Member States, they may result in significant differences in the level of investor protection between industry sectors, as well as an 'unlevel playing field' for originators and distributors. The question therefore arises over whether European action is justifiable, and over the form that it should adopt.

Drawing on the results of an extensive process of consultation, this Impact Assessment is an important step in determining whether there is substance to these concerns and, if so, in setting out the broad lines of a policy response to the problems identified. It is envisaged that this policy orientation would be communicated in the form of a Communication. If it is concluded that a European-level response is justified, further impact assessment work would then be required to identify specific measures embodying an optimal trade-off between the costs and benefits of intervention.

2. Procedural Issues

The genesis of this Impact Assessment lies in a request from the ECOFIN Council in May 2007 for the European Commission to examine the coherence of disclosure and distribution regimes in EU law applying to different types of retail investment product.

In response to this request, the European Commission has consulted extensively with stakeholders. A written call for evidence was launched in October 2007, which attracted 80 responses from national regulators, consumer associations and the originators and distributors of all of the products concerned. The results of this consultation were published in a Feedback Statement in March 2008. A technical workshop was held with industry representatives in May 2008. This provided a forum for an exchange of views between industry experts on the risks to investor protection and the adequacy of existing European regulatory provisions. There followed a high-level Open Hearing in July 2008, which brought together over 300 senior representatives from industry, consumer associations, national regulators and the European institutions to discuss the development of the market and potential risks to retail investors. Records of this consultation, which respected the Commission's minimum standards on public consultation, are available on the European Commission website. See: http://ec.europa.eu/internal_market/finances/docs/cross-sector/feedback_statement_srips.pdf . , See: http://ec.europa.eu/internal_market/finances/docs/cross-sector/minutes_workshop_en.pdf . , See: http://ec.europa.eu/internal_market/finances/docs/cross-sector/hearing-record_en.pdf .[1][2][3]

See: http://ec.europa.eu/internal_market/finances/docs/cross-sector/feedback_statement_srips.pdf .

See: http://ec.europa.eu/internal_market/finances/docs/cross-sector/minutes_workshop_en.pdf .

See: http://ec.europa.eu/internal_market/finances/docs/cross-sector/hearing-record_en.pdf .

Table 1 : Preparatory Steps

Major steps / inputs|Timing|

ECOFIN request|May 2007|

Launch of Call for Evidence|October 2007|

Publication of Feedback Statement on Call for Evidence|March 2008|

Industry Workshop|May 2008|

Open Hearing|July 2008|

Presentation of IA report to the IAB|December 2008|

These formal events have been supplemented by a series of discussions with consumer representatives (FIN-USE, Financial Services Consumer Group), regulators (Financial Services Committee, European Securities Committee, European Insurance and Occupational Pensions Committee) and industry representatives. The consultation process revealed a variety of stakeholder views on the issues discussed in this impact assessment. The opinions and evidence received have informed the analysis that follows.

An Inter-service Impact Assessment Steering Group, chaired by DG Internal Market and Services, was established in October 2008, involving representatives from DG Competition, DG Economic and Financial Affairs, the Secretariat General, the Legal Service and DG Health and Consumer Protection. The Group met on 10 October, 27 October and 11 November 2008.

On 20 November 2008, a draft Impact Assessment was submitted to the Impact Assessment Board, which issued its opinion on 19 December 2008. The recommendations of the Board led to changes in the draft Impact Assessment. In particular, the statement of objectives and the link between this initiative and the response to the financial crisis has been clarified; the case for European-level action further elaborated; the discussion of the link between the evidence cited and weaknesses in EU law was expanded (although quantification of aggregate investor detriment was not possible on the basis of the available data); and the statement of policy options and the assessment of their relative effectiveness and efficiency was clarified, including to confirm that the options are not mutually exclusive.

3. Problem definition

The following sections should be read in conjunction with the 'problem tree' in Annex 1.

3.1. Market context and problem drivers

Comparable packaged retail investment products are originated in different industry sectors…

There are a wide variety of packaged investment products available to retail investors, originated in different financial sectors. The term 'retail investor' is here taken to mean a non-sophisticated, non-institutional investor. The primary focus is the individual or household - the population of the EU can therefore be considered as potential investors in this type of product – although the policy issues discussed may also be relevant to SMEs and municipalities.

The principal families of packaged retail investment product are described in the box below. See Annex 1 for further description of the product scope of this work. In the absence of a widely-accepted legal definition of 'retail investment products', the product scope is defined in terms of the common characteristics of these product types. Defining the precise boundaries of these product families could form part of the follow-up to the Communication. The list of product families that exhibit these characteristics is not exhaustive; ultimately, any measures would need to take account of the possibility that new retail investment products will emerge over time.[4]

See Annex 1 for further description of the product scope of this work. In the absence of a widely-accepted legal definition of 'retail investment products', the product scope is defined in terms of the common characteristics of these product types. Defining the precise boundaries of these product families could form part of the follow-up to the Communication. The list of product families that exhibit these characteristics is not exhaustive; ultimately, any measures would need to take account of the possibility that new retail investment products will emerge over time.

These definitions should not be taken to be exhaustive. Further work will be necessary to better refine the definition of the products covered.

Investment (or mutual) funds. Investment funds are a form of collective investment vehicle that invest the pooled funds of a large number of investors for a fee. Funds raise money by selling 'units' of the fund to investors. In the EU, investment funds can be either UCITS ('Undertakings for Collective Investment in Transferable Securities', as harmonised by the UCITS Directive), or nationally regulated funds (non-harmonised funds or non-UCITS).

Investments packaged as life insurance policies. In unit-linked life insurance policies a portion of the premium is used to purchase life cover (the sum assured) with the balance invested in a fund such as a UCITS. The return on the policy is linked to the performance of the funds. As opposed to traditional life insurance products, unit-linked policies usually do not guarantee the payment of a determined financial amount in particular in the case of death / survival, but instead an amount which is a multiple of the market value of one or several units. Therefore, by definition, the policy holder bears the investment risk.

Retail structured securities. Structured securities are derived from or based on a single security, a basket of securities, an index, a commodity, a debt issue and/or a foreign currency. Normally in a structured security an investment bank promises to make, at a pre-determined time, a payout based on a pre-determined formula. The majority of structured securities offer full protection of the principal invested at the end of their term, whereas others offer leveraged returns but limited or no protection of the principal. They may be sold to investors as, inter alia, certificates, structured notes (bonds) or warrants.

Structured term deposits. Structured term deposits offer a combination of a term deposit with an embedded option or an interest rate structure. They are designed to achieve a specific payoff profile, which they achieve through transactions in derivatives such as interest rate and currency options.

The precise nature of the investment proposition, the legal structure and the tax treatment of the products differ, both between product families and across Member States. However, they share the same core functionality – namely providing retail investors with the prospect of capital accumulation over the medium to long term – and compete for the same retail savings.

We distinguish 'packaged' products from investments in single equities or (unstructured) bonds. Some of the policy issues described in this paper also apply to these latter categories; however, the process of packaging investments adds an additional layer of complexity and cost that may make the key characteristics of the investment less transparent to the end investor.

As Chart 1 indicates, around €10 trillion were estimated to be invested through these product families by year end 2007, which is equivalent to around 80% of EU GDP. Precise data are not available for all the products and such this chart is intended to be indicative only; note that 2008 has seen significant net outflows in relation to most packaged retail investment products, in some cases these have been substantial. Due to data limitations, figures for unit-linked life insurance and deposits are likely to overestimate capital invested in the specific products under consideration. There are also instances of double-counting. While these product types are designed and marketed primarily to retail investors, the figures include capital invested by institutional investors, which can be a significant proportion. See Annex 1 for further discussion of the data. [5]

Due to data limitations, figures for unit-linked life insurance and deposits are likely to overestimate capital invested in the specific products under consideration. There are also instances of double-counting. While these product types are designed and marketed primarily to retail investors, the figures include capital invested by institutional investors, which can be a significant proportion. See Annex 1 for further discussion of the data.

Chart 1 : Estimate of capital invested through packaged retail investment products (€ trillion)

(...PICT...)

Source EFAMA, CEA, retailstructuredproducts.com and ECB

… and are sold through similar distribution channels…

Packaged retail investment products are distributed both by their originators, be they fund managers, banks or insurance companies, and by a variety of intermediaries. The predominant model of retail distribution varies significantly between Member States. See Annex 1 for more information on the channels employed for the sale of retail investment products. However, a feature of many of these models, including the 'bancassurance' model of financial distribution prevalent in many Member States, and the independent financial adviser model in the UK, is that different product types are available from the same distributors. This convergence of product availability across a variety of different sales channels allows prospective investors or indeed intermediaries to consider and compare products belonging to different product families when contemplating an investment. This opportunity to 'look across' multiple product families is likely to lead retail investors to actively compare product offerings. In addition, it is likely to foster the expectation that the level of investor protection embodied by each product type is equivalent.[6]

See Annex 1 for more information on the channels employed for the sale of retail investment products.

… yet are subject to different disclosure and distribution rules at European level.

Retail investment markets are characterised by a steep asymmetry of information and expertise between the originators and distributors of investment products, on the one hand, and the retail investor, on the other. The latter typically exhibit a low level of financial sophistication and hence are ill-equipped to assess the relative merits of the investment propositions on offer. Pre-contractual product disclosures and in particular financial advice from intermediaries thus play an influential role in the decision-making process. The distribution of packaged retail investment products is also however subject to potential conflicts of interest between originators, distributors and investors. For example, payments by product originators to distributors, for instance in the form of commission payments, create a potential for a divergence of interest between sellers and buyers of packaged retail investment products.

Regulation has sought to mitigate these market failures and hence to limit investor detriment. One regulatory approach is to target the product itself, by limiting the access of retail investors to certain product types or directly regulating the characteristics of the products (known as 'product regulation'). While this is one of the approaches adopted in the UCITS Directive, it is not a widely employed regulatory technique. The practical challenges associated with harmonising product features for all product types would be immense and the net market outcomes deleterious, particularly through the impact of such restrictions on product competition, diversity and innovation. This approach is not considered to be within the scope of this investigation.

Regulation in this sector more commonly focuses on the sales process, that is, the interface between the investor and the originator and/or intermediary. To mitigate risks to investors, regulation focuses on ensuring that investors are adequately informed about the characteristics of the product and are treated fairly by product distributors . Two types of regulation are particularly relevant in this context:

· Rules on the form and content of pre-contractual product disclosures and marketing materials; and

· Rules governing the conduct of business of product distributors and the avoidance, management and disclosure of conflicts of interest in the sales or advice process. Collectively, these provisions can be referred to as selling rules . In the event that these controls fail and investor detriment results, national authorities may have acted to mitigate the impact on retail investors through guarantee or redress schemes of various types. For example, financial ombudsmen provide a means of redress for investors mistreated by financial intermediaries. Guarantee schemes exist in the insurance, banking and investment sectors to provide cover in the event of the insolvency of a product provider. In the insurance sector the situation is diverse, and the Commission is currently conducting a consultation on this subject: see http://ec.europa.eu/internal_market/insurance/guarantee_en.htm . The focus of this work, however, is on the ex ante controls in place rather than ex post guarantee and redress mechanisms. [7]

In the event that these controls fail and investor detriment results, national authorities may have acted to mitigate the impact on retail investors through guarantee or redress schemes of various types. For example, financial ombudsmen provide a means of redress for investors mistreated by financial intermediaries. Guarantee schemes exist in the insurance, banking and investment sectors to provide cover in the event of the insolvency of a product provider. In the insurance sector the situation is diverse, and the Commission is currently conducting a consultation on this subject: see http://ec.europa.eu/internal_market/insurance/guarantee_en.htm . The focus of this work, however, is on the ex ante controls in place rather than ex post guarantee and redress mechanisms.

The focus in this impact assessment is on regulation in these two key areas.

For most product types, a substantial body of law already exists at European and national level to ensure that investors are informed of the characteristics of their investments and are treated fairly and professionally by distributors.

However, Community law in this area has been developed on a largely sectoral basis. As a result, the rules governing disclosure and selling practices vary according to the sector in which the product is originated and in which the intermediary operates. There are overlaps - for example, the application of MiFID to the sale of both funds and structured securities - but by and large the products and their sales are subject to distinct regulatory provisions. There is no single, coherent approach at European level to disclosure and selling rules for packaged retail investment products. The following table illustrates this 'regulatory patchwork'.

Table 2 : Disclosure rules and intermediary regulation in Community law for packaged retail investment products

|UCITS |Non-harmonised investment funds|Unit-linked life insurance policies|Structured securities and closed-end funds|Structured term deposits|

Rules on product information applying to manufacturers, issuers or intermediaries |Simplified Prospectus of UCITS Directive |MiFID (high-level product disclosure requirements apply to MiFID intermediaries when selling financial instruments)|CLD|Prospectus Directive 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.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.|No rules at EU level|

|MiFID 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.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.(high-level product disclosure requirements apply to MiFID intermediaries when selling financial instruments)||Insurance Mediation Directive Directive 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on insurance mediation. for some product disclosure requirementsDirective 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on insurance mediation.|MiFID (high-level product disclosure requirements apply to MiFID intermediaries when selling financial instruments)||

|E-commerce Directive or Distance Marketing of Financial Services Directive|

Selling rules|MiFID|MiFID|Insurance Mediation Directive|MiFID|No rules at EU level|

|UCITS Directive |||||

|E-commerce Directive or Distance Marketing of Financial Services Directive|

A brief description of the relevant provisions of these instruments is provided in Annex 1.

3.2. Problem description

The preceding discussion has identified three key features of the market for packaged retail investment products:

· Retail investment products are originated in different industry sectors but often targeted to satisfy similar retail investment needs;

· A wide range of different products are made available to retail investors through similar distribution channels; and

· European rules on disclosure and selling differ according to the legal status of the product and the channel through which it is distributed; for some products and sectors, there are no applicable rules.

The regulatory patchwork results in considerable regulatory complexity. Different types of product are subject to different disclosure obligations at European level. Similarly, different types of intermediary are subject to different obligations with respect to the conduct of their business and the management of conflicts of interest. When the same intermediary offers products from different industry sectors, different rules will apply. For certain products and intermediaries, there are no applicable rules at European level.

Variation in the form and content of rules is not a problem per se . Differences in sectoral approaches may be justified by the distinct characteristics of the products and intermediaries in those sectors, with regard for example to risks taken by the originating and distributing institutions; the risks faced by consumers purchasing the products; or the manner in which products are sold. However, the emergence of comparable products governed by significantly different regimes and the growing convergence of product availability within distribution channels serve to weaken these distinctions and hence the logic of a differentiated approach.

In particular, the 'regulatory patchwork' at European level poses two key regulatory concerns:

· The first is that it creates or amplifies risks of investor detriment in the sectors concerned. For example, deficient or absent rules on pre-contractual product disclosure may result in a lack of transparency on the costs, risks or expected performance of a particular product. As a consequence, investors would be unable to compare competing products or understand the products they are considering buying. Similarly, missing or ineffective rules on selling disciplines or conflict of interest management would amplify risks of mis-selling.

· The second, related, concern is that differences in the level of investor protection between sectors create an unlevel playing field with respect to disclosure and selling rules for product originators and distributors. This may distort the market in favour of products subject to weaker regulation, thereby exacerbating the risks of investor detriment described above.

These concerns are significant enough to have provoked responses from national regulators in several Member States. However, uncoordinated action of this type presents a third barrier to the efficient operation of the retail investment market.

· Divergent national regulatory approaches , triggered by deficiencies in European rules, may increase the cost of selling investment products in multiple national markets, or on a cross-border basis. While differences in disclosure and selling rules are unlikely to be the most important barrier to cross-border trade, they may nevertheless act as a brake on the development of a single market in these products.

3.2.1. Risks of investor detriment

Packaged retail investment products normally expose the investor to a degree of investment risk . Depending on market movements, an investment may deliver a positive or negative return, with the range of possible outcomes determined partly by the features of the product (for example, downside risk may be eliminated by the existence of a robust capital guarantee, at the expense of reduced potential for gains). By contrast, the risk of investor detriment refers to the risk of product mis-selling and/or ill-informed investment decisions resulting from investors being either inadequately informed of the key characteristics of the product they are offered, or being otherwise mistreated by originators or distributors in the sales process.

If risks of investor detriment crystallise, the impact could take the form of financial losses for investors, or where there is no absolute loss, the opportunity cost of selecting an investment with a different risk-reward profile to that which was intended or expected. Opportunity cost can be difficult to pin down; often it can only become clear over the longer duration that a product has failed to perform in the manner expected. Detriment can also be crystallised indirectly – for instance, a poor understanding of the performance structure of an investment may lead to an investor significantly mis-timing their entry and exit into the market , for example because they did not expect the investment to exhibit short term volatility.

A systematic pattern of product mis-selling or inadequate disclosure of product features may result in retail investors losing confidence in the products and in the institutions originating and distributing them. Impaired reputations can result in a loss of business and a reduction in revenues and profits. This impact may be felt unevenly across the market, i.e. the originators and distributors of certain products may gain while those selling products in which investor confidence has been lost will suffer.

However, there is also a risk of contagion. It is plausible that a loss of faith in particular products could have knock-on effects on the whole investment market. In the current environment, adverse market conditions have triggered a flow of retail savings away from investment products and towards basic savings accounts or cash balances. Such effects could be accentuated if investor confidence were impaired not only by market developments but by losses that might not have been reliably foreseen on the basis of information disclosed or advice given. Investor detriment in one sector may not simply lead to a redistribution of savings between sectors, but rather a reduction in the propensity to make use of any type of packaged retail investment product. To the extent this implies that productive investment opportunities are foregone, such a development may impact negatively on the efficiency of resource allocation and may compromise the ability of individuals to make financial provision for later life. This is a potentially significant issue at time when public pension systems are under strain.

The Call for Evidence and subsequent discussions with stakeholders, including national regulators, has produced a significant body of evidence and expert opinion to use as an initial basis for assessing these issues. Despite this, the risks of investor detriment – and their associated impacts – remain intrinsically difficult to quantity, particularly when ineffective disclosures or inadequate selling practices result in poor investment decisions of which the opportunity cost is high, but measurable financial losses are not incurred. Such incidents are best observed by those closest to the respective markets. In assessing these risks, we must therefore rely to a large extent on the expert opinion of consumers, national regulators and market practitioners.

The evidence that follows is sub-divided into two sections: examples and perceptions of risks crystallising as a result of ineffective pre-contractual product disclosures and misleading marketing material; and risks associated with inadequate regulation of selling processes. The examples included have been selected solely to illustrate the risks most frequently identified; they are by no means exhaustive or intended to provide a comprehensive overview of the evidence.

3.2.1.1. Inadequate pre-contractual product disclosures and marketing rules

The evidence points to four types of problem with existing pre-contractual disclosures.

· The first is that the content of disclosures may provide a misleading or partial account of a products features, such as its costs; the range of possible returns; associated risks; limits to capital guarantees provided; or any restrictions that apply (notably on when an investor may be able to take their money out). The investor would not then be in a position to take an informed decision. A lack of balanced or transparent information may result in investors giving undue weight to the elements that are disclosed more prominently, such as tax benefits, capital protection or estimates of the maximum possible return.

· Secondly, inconsistent disclosure practices may also prevent the effective comparison of alternative investment propositions by retail investors, particularly relevant as charging models can be very different.

· Thirdly, even if the relevant 'key' information is provided, it may not be presented in such a way that it can actually be used by non-sophisticated, retail investors to understand the product or compare it with others.

· Fourthly, and relatedly, there is an abundance of research to suggest that retail consumers suffer from 'information overload'. If disclosures are excessively long and drafted using technical jargon instead of using simple, understandable language, retail investors may be deterred from using them. For example, see National Consumer Council, Warning: Too Much Information Can Harm .[11]

For example, see National Consumer Council, Warning: Too Much Information Can Harm .

An additional, related, problem is that of misleading marketing materials. Unfair, unbalanced or otherwise misleading marketing material may induce an investor to select a product that is a poor match for his/her investment profile. Misleading advertising may also result in the investor paying insufficient attention to the content of more detailed product disclosures.

These problems are common to disclosures in all markets and have important implications for rule-making at national and European level (there have been some steps at both national and European level to tackle them). The focus here is on the extent to which current disclosure obligations in Community law might be failing to adequately mitigate these problems or contribute to them. Here we present some illustrative examples of the evidence of such failures, on a product-by-product basis. Evidence drawn from responses to the Call for Evidence and the records of the Industry Workshop and Open Hearing is not individually referenced.[12]

Evidence drawn from responses to the Call for Evidence and the records of the Industry Workshop and Open Hearing is not individually referenced.

Unit-linked life insurance policies

Many responses to the Call for Evidence on unit-linked life insurance policies highlighted deficiencies with regard to the disclosure of likely performance and of the costs associated with this type of investment.

The response from the insurance supervisors in CEIOPS highlighted the disclosure of 'chain costs' as a particular problem (the use of insurance 'wrappers' entails the addition of costs both at the level of the insurance company and the originator of the underlying investment).

More broadly, the Dutch AFM and other regulators have reported that differences in regulation between life insurance products and mutual funds have caused significant problems. They argue that transparency of costs and inducements is not achieved in the insurance sector solely on the basis of EU requirements, so to the extent that the EU requirements set the standard of disclosures, prospective investors are unable to weigh these factors up against other features that might be highlighted, such as the tax advantages of the product. This is considered to have resulted in the sale of insurance products even where mutual fund investments offering similar asset exposures with lower charges might have offered better risk-adjusted performance.

A recent example of such a potential distortion in sales is the alleged misselling of equity-linked insurance products in the Netherlands, which resulted in a class action lawsuit. The complaint was that there was insufficient disclosure of the costs associated with those policies, leading to investment returns that were significantly lower than investors had been led to expect and penalties on early withdrawal that were not expected. Following intervention by the Dutch Insurance Ombudsman and its replacement, the Financial Services Ombudsman, out of court settlements were reached with certain distributors of such products. See http://www.kifid.nl/uploads/2008-03-04-Recommendation_of_the_Financial_Services_Ombudsman.pdf[13]

See http://www.kifid.nl/uploads/2008-03-04-Recommendation_of_the_Financial_Services_Ombudsman.pdf

There are other examples. For instance, a Belgian consumer association has warned that rules for advertising on unit-linked life insurance in Belgium do not specify how information on past returns should be presented so as to avoid misleading prospective investors. See http://www.test-achats.be/map/src/522123.htm . The association encountered an insurance company advertising a unit-linked life contract by referring to the return achieved in 2006, without mentioning the return earned in 2007, which was considerably weaker. The same association is currently suing an insurance company for misleading advertising. In particular, the company is considered to have given undue prominence in its marketing material to the return on only one of the funds underlying the insurance policy (the best performing fund), rather than the basket of funds in which client's assets were invested.[14]

See http://www.test-achats.be/map/src/522123.htm .

The management and / or disclosure of potential conflicts of interest is addressed in Section 3.2.1.2.

Investment funds

Consultation on possible amendments to the UCITS Directive revealed that most respondents felt that the Simplified Prospectus (a shorter summary document required for all UCITS since 2005) had failed to provide key information in a form that was easily understood by the average retail investor. This finding triggered the ongoing work on developing Key Investor Information. Respondents to the Call for Evidence reported similar problems for non-harmonised funds and closed-ended funds.

In France, the Final Court of Appeal recently sanctioned a commercial bank over failure of compliance with the combination of rules on product disclosure and marketing communications. The Court found that the firm did not mention in its advertisement the downside risk that a formula (structured) fund presented. See Arrêt n° 740 du 24 juin 2008 06-21.798 Cour de cassation - Chambre commerciale. Problems with formula funds were also noted elsewhere in the French market. [15]

See Arrêt n° 740 du 24 juin 2008 06-21.798 Cour de cassation - Chambre commerciale.

In Belgium, a consumer association recently criticised an advertising campaign for a structured fund distributed by a Belgian commercial bank. See http://www.test-achats.be/map/src/522123.htm . It is claimed that adverts placed undue emphasis on a guaranteed rate of return, without a clear indication that this return would only be achieved on half of the capital invested.[16]

See http://www.test-achats.be/map/src/522123.htm .

The Dutch AFM have reported that the mandatory information provided in the prospectus for closed-ended real estate funds is not well-tailored to this type of investment, which is growing in popularity in the Netherlands. The result is that investors cannot understand the expected return, the costs and most importantly the level and nature of the risks involved in these investments.

In Germany, a number of legal proceedings have highlighted problems of mis-selling, unfair marketing, and misleading or inaccurate product information with respect to closed-ended funds.

In the United Kingdom, the FSA have recently published an assessment of the standards of disclosure documents across the whole range of retail investment products, which found many to be inadequate and unlikely to be understandable for their target audience. See http://www.fsa.gov.uk/pubs/other/key_features.pdf .[17]

See http://www.fsa.gov.uk/pubs/other/key_features.pdf .

Retail structured securities

Many stakeholders have argued that structured product disclosures do not adequately describe the costs associated with the product or the likely range of performance outcomes. Prospectuses produced in accordance with the Prospectus Directive – including the summary prospectus - were not considered to be effective disclosures for structured securities, since they focus on the issuer rather than the product and are both lengthy and technical.

The European Securities Markets Expert Group, in their review of the functioning of the Prospectus Directive, found that '"[...] from the point of view of the investors, the Prospectus Directive has failed to produce an effective means of communication. For example, the average length of prospectuses has increased dramatically due to the requirement for additional information. The length and complexity of prospectuses make them more a sort of 'liability shield' for the persons involved in the preparation (issuers, intermediaries, auditors, law firms and competent authorities), effective ex post in minimizing the risk of potential litigation, rather than a document to be used ex ante by an investor when making investment decisions. " They added that " many investors have difficulties in understanding the technical language and the complex structure of information as well as analyzing the importance of various types of information. As a consequence, most retail investors rely only on the marketing material prepared in connection with a public offering. The summary is often a simple “cut and paste” exercise of various parts of the prospectus without any attempt to simplify the language of such parts (often very technical) as required by the Prospectus Directive. " See http://ec.europa.eu/internal_market/securities/docs/esme/05092007_report_en.pdf .[18]

See http://ec.europa.eu/internal_market/securities/docs/esme/05092007_report_en.pdf .

Obligations in the Prospectus Directive are supplemented by additional disclosure requirements on intermediaries in MiFID, which relate primarily to the services provided by the intermediary but also to the financial instruments they may be selling. However, many stakeholders argued that these provisions are subject to inconsistent implementation in Member States and do not go far enough in ensuring that the relevant items are clearly disclosed.

In a cross-country survey, Deloitte found that 'material differences exist between investment funds and structured notes in the nature and level of detail of information disclosed to the investors … this is clearly the case for characteristics, risks and costs. These differences make it difficult or even impossible for investors to compare in detail all characteristics of the products. The differences also result in a different quality of information given to investors .'

The Dutch AFM published an analysis of developments on the market for structured products in May 2007, arguing that many are difficult for retail investors to understand. These developments constituted grounds for an 'exploratory analysis of structured products', http://www.afm.nl/corporate/default.ashx?DocumentId=9246 . which concluded that …' the information provided to investors is not as it should be. Prospectuses do not focus sufficiently on the information that consumers need to make well-considered investment decisions. In addition, the legal entity chosen for the products means that financial information leaflets are not obligatory … The AFM feels investors may select an unsuitable product, which will jeopardise the proper operation of the market and, if investors are disappointed in their choices, the confidence in the market'.[19]

http://www.afm.nl/corporate/default.ashx?DocumentId=9246 .

In another example of the issues being raised, the Czech National Bank has expressed concerns in relation to an index-linked bond , the yield of which is based on a specific underlying asset (for example the performance of an index or an exchange rate). The product was sold as a 'guaranteed bond', while it in fact presented a significantly higher risk than standard guaranteed bonds.

In the United Kingdom, the FSA has fined or some cases banned a number of product manufacturers and intermediaries in relation to sales and marketing of certain kinds of complex 'high income products', typically known as precipice bonds. These so-called "precipice bonds" were linked to derivatives such as the performance of an index or indices or baskets of stocks. They were often structured as offshore investment companies or offshore insurance companies and so are not regulated by the FSA. They were structured to deliver a high income without protection against loss of the initial capital invested; return of the original capital was linked to the performance of an index/indices or a basket of stocks. The risk of capital loss (particularly high given the income being taken) was often not clearly explained. The FSA had previously issued a series of warnings in relation to the products, such as an alert in December 1999 which urged consumers to consider carefully the level of risk they were willing to accept before investing in so-called high income products; the FSA reiterated in later communications that consumers should be cautious when investing in bonds that promise income but carry a high risk that investors may not receive back all, or any, of their original investment, and required regulated firms to improve the information they provided to consumers.. See for example FSA/PN/122/2002 of 15/12/2002 'Precipice bond' investors may not get their money back, FSA warns". See also http://www.fsa.gov.uk/pubs/guidance/guidance7.pdf . [20][21]

These so-called "precipice bonds" were linked to derivatives such as the performance of an index or indices or baskets of stocks. They were often structured as offshore investment companies or offshore insurance companies and so are not regulated by the FSA. They were structured to deliver a high income without protection against loss of the initial capital invested; return of the original capital was linked to the performance of an index/indices or a basket of stocks. The risk of capital loss (particularly high given the income being taken) was often not clearly explained.

See for example FSA/PN/122/2002 of 15/12/2002 'Precipice bond' investors may not get their money back, FSA warns". See also http://www.fsa.gov.uk/pubs/guidance/guidance7.pdf .

Structured term deposits

Many responses to the Call for Evidence noted that there were no European rules that applied to structured term deposits as a class of product. (In this area, no specific targeted examples of investor detriment were provided.) The Joint Forum reiterated the point, and noted that there are retail investment products (such as structured term deposits) that are not subject to disclosure regulation at EU level. Noting that similar lacunae existed in other jurisdictions, they suggested that ' this is [an issue] that governments should consider '. Joint Forum, Customer Suitability in the retail sale of financial products and services , April 2008.[22]

Joint Forum, Customer Suitability in the retail sale of financial products and services , April 2008.

There is evidence that some of same issues as are raised for other classes of PRIP apply. For instance, in Poland in the first half of 2008, the Polish Financial Supervision Authority (PFSA) ordered some banks to withdraw advertisements of structured term deposits due to the violation of professional standards and ethical codes in operation. The PFSA was concerned that these placed excessive emphasis on a product’s benefits for the customer and deliberately omitted other important product characteristics, e.g. penalties for early withdrawal of funds.

Summary

The examples presented in this section do not in themselves constitute systematic evidence of market or regulatory failure with respect to product disclosure. Particular instances of investor detriment do not necessarily indicate a failure in the European regulatory framework; they may instead relate to failures in the transposition or enforcement of those rules in the Member States. However, it is apparent that the examples cited cluster around areas where expert opinion, including from the regulatory and investor communities, indicates that the disclosure provisions of Community law are comparatively weak, or indeed absent, exposing less sophisticated investors in particular to potential detriment. This suggests that there is scope for considerable improvement in this area, across the full spectrum of packaged retail investment products.

The recent experience of the financial crisis has further corroborated these conclusions. Investors have suffered from adverse conditions and have found, in some cases that products have not performed as might reasonably have been expected. A particular issue affecting a number of sectors has been the performance of products sold with capital guarantees. The default of counterparties providing such guarantees has exposed retail investors to the crystallisation of counterparty risks of which they were not fully aware. As the lessons are drawn from the crisis, the descriptions of the nature and conditions attached to guarantees are coming under increased scrutiny.

3.2.1.2. Inadequate care or professionalism in the selling process

Risks of investor detriment may also arise from inadequacies in the regulation of the selling practices of product distributors. These inadequacies relate to two areas:

· Insufficient objectivity and professionalism in sales or advice results in the mis-selling of products that are a poor match for the risk profile (or other characteristics or needs) of the prospective investor.

· The financial incentives provided to distributors by the originators of particular products or other distributors or 'packagers' of products for the sale of their products may result in a conflict of interest between the distributor and the prospective investor. In particular, differences in payment levels may lead a distributor to sell those products that generate the highest payments, rather than those best suited to the needs of the end investor.

Feedback received in relation to gaps or inconsistencies in the regulation of intermediaries at European level consisted primarily of anecdotal evidence and comparison of legal provisions. It was frequently highlighted that given the short period of time that MiFID and IMD rules have been in force, it would be premature at this stage to draw firm conclusions about their impact and the residual risks to retail investors.

However, it was widely accepted that there are marked differences in conduct of business rules between sectors. See Annex 1 for an outline of the relevant provisions of Community law. For example, MiFID contains a set of differentiated selling rules, where the requirements depend on the type of service being offered and the type of client being served. For retail investors, when providing investment advice or portfolio management services, MiFID intermediaries must perform a test of the suitability of any proposed investment. When providing other services, an 'appropriateness' test may be required. By contrast, in the insurance sector, the IMD requires that insurance intermediaries provide advice on the basis of a fair analysis of a suitable range of contracts available on the market and to advise products that are 'adequate' for the needs of the consumer. There are no rules in place at European level for the distribution of structured deposit products.[23]

See Annex 1 for an outline of the relevant provisions of Community law.

The Joint Forum also noted once again that there are retail investment products (such as structured term deposits) that are not subject to conduct of business regulation at EU level. Noting that similar lacunae existed in other jurisdictions, they suggested that ' this is [an issue] that governments should consider '.

It was also noted that there are gaps in the application of distribution rules when products are sold directly by originators – for example, fund managers or insurance companies - rather than by an intermediary. No evidence was provided to link these gaps with instances of investor detriment but it is unclear why rigorous selling disciplines should not apply to the direct - as well as intermediated - distribution of packaged retail investment products (though of course the service provided may differ in other respects).

With regard to conflicts of interest , MiFID has introduced a sophisticated regime for the avoidance, management and disclosure of conflicts of interest and detailed provisions concerning the payment of inducements to intermediaries; both regimes apply to the sale of funds and structured securities. The IMD, by contrast, does not contain comparable conflict of interest or remuneration disclosure rules, although it does require intermediaries to tell the customer whether they are giving advice based upon a fair analysis (for instance, by comparing the features of a sufficiently large range of insurance contracts) or whether they have contractual obligations with one or more insurers.

The regulation of conflicts of interest in the insurance sector drew criticism in the Call for Evidence.

CEIOPS' Members, through their combined response to the Call for Evidence, concluded that ' there is a gap in terms of the coverage of conflict of interest rules that should be addressed in the course of the revision of the IMD '.

The Dutch AFM argued that the duty of care obligations in force in the insurance sector were not as robust as those found in other sectors.

The Joint Forum found that disclosures of conflicts of interest (for example, ownership structures of the sales agent, or remuneration to be received) are generally less rigorous for sales of insurance than for other products. Joint Forum (2008), p.2[24]

Joint Forum (2008), p.2

Consultation revealed a divergence of view on whether these differences were of concern from an investor protection or competitive standpoint. We do not as yet have strong evidence of the extent to which such inconsistencies and gaps might have resulted in specific investor detriment or competitive distortions. As mentioned above, practical experience with this legislation remains limited and as such it would be premature to draw firm conclusions at this stage on whether these provisions have successfully mitigated the risks associated with lax selling practices or conflicts of interest.

There is nonetheless prima facie cause for concern over the regulatory patchwork in this area. Retail investment business is typically intermediated rather than direct, and many investors rely on third parties when making investment decisions. Consequently, a failure to conduct business professionally or to effectively manage conflicts of interest could be a particularly significant cause of investor detriment. Inconsistencies in intermediary requirements between types of products might also distort competition, leading to further detriment by means of regulatory arbitrage effects.

3.2.2. Competitive distortions resulting from an 'unlevel playing field' between product types and distribution channels

A second consequence of variations in disclosure and distribution rules at European level between sectors is that certain originators/distributors may be placed at a competitive disadvantage with respect to market participants originating or distributing other product types.

This 'unlevel playing field' may manifest itself in two ways.

· First, as a consequence of regulatory differences alone, originators/distributors in a particular sector may face higher compliance costs (for example due to the need to produce additional disclosure documents or to develop internal systems for the management and reporting of conflicts of interest) or otherwise more burdensome requirements than those in other sectors. This may affect both the cost of the product offered to the consumer and the ease with which the sector can innovate and bring new products to market.

· Second, as described in the previous section, differences in regulation may distort consumer decision-making. For example, weak disclosure standards may result in inadequate disclosure of costs or risks, with the result that a product appears more attractive than a competing product for which these factors are more transparent.

These factors may in turn create incentives for originators/distributors to package products in particular ways so as to avoid more burdensome regulation. A process of 'regulatory arbitrage' would thus be set in motion, working in favour of those products subject to less stringent regulation. If this were the case, the risks of investor detriment outlined in the previous section would be amplified.

To what extent can we demonstrate that the purported unlevel playing field with respect to disclosure and distribution rules at European level has given rise to competitive distortions? At the aggregate level, there is limited evidence of shifts of savings between product families on a pan-European scale. Data on net sales indicate that the proportion of net sales accounted for by investment funds has remained roughly constant since 2002. However, there are tentative signs that that the structure of the market is changing. Fund sales remained roughly constant between 2005 and 2006, whereas growth was strong for both retail structured securities and unit-linked life insurance policies. This trend was most apparent in the German, Italian and Spanish markets.

Chart 2: Net sales of packaged retail investment products (€ billion)

EU|Germany|

(...PICT...)|(...PICT...)|

Italy|Spain|

(...PICT...)|(...PICT...)|

Sources: EFAMA - EVCA – AIMA, Eurohedge, CEA and www.structuredretailproducts.com .

Sales data are volatile and do not span a sufficiently long time period for us to be confident that wholesale changes in market structure are taking place. Moreover, even if we could demonstrate that such changes were occurring, we could not confidently attribute these trends to differences in disclosure regimes and the regulation of intermediaries. Sales patterns are affected by a variety of factors on the demand and supply side. Commercial decisions by product providers and evolution in consumer preferences are likely to be influential. For example, capital protected products – such as structured securities – are seen to gain in popularity during uncertain economic times.

Producers cannot move seamlessly from one sector to another. The process is not frictionless. Relevant regulatory authorisations are required, for example, to issue securities or to sell insurance contracts. The infrastructure, skills and expertise for supporting active fund management may also vary greatly from that required to originate structured securities. Therefore, even if differing selling rules created an incentive for arbitrage, the response from the supply side may be limited.

It is also important to recognise that disclosure and distribution rules are only one component of the 'playing field' on which originators and distributors compete. Tax is another highly relevant factor. For reasons of public policy, it has been common for Member States to apply favourable tax treatment to particular product types. There is evidence that this exerts a powerful influence on savings flows. For example, the popularity of insurance-based products in France, even for the distribution of UCITS, can largely be attributed to the favourable tax treatment that these products enjoy. Similar arguments can be made in most Member States. Responsibility for taxation policy resides with Member States and hence options for levelling this element of the 'playing field' are not discussed further here.

While it is difficult to draw firm conclusions about the importance of regulatory arbitrage, it remains clear that all of the product types described are used extensively by retail investors, which is in itself a case for ensuring that risks of investor detriment are effectively mitigated. Regulatory arbitrage, or the active migration of savings from one product to another, would amplify these risks, but the existence of widespread arbitrage is not a precondition for these risks to emerge.

3.2.3. Divergent national responses: impact on single market

The problems flowing from the European regulatory patchwork for packaged retail investment products described in the previous section have been widely acknowledged by Member States. Perhaps the clearest indication that national regulators consider differences in rules between sectors to be of real, rather than purely theoretical, significance is that many have supplemented European rules with additional requirements at national level. This has been done both to enhance the level of investor protection and to 'level the playing field' between alternative investment propositions.

This is reflected in the conclusions of a comprehensive survey of national regulatory views on the issue conducted by the three 'Level 3 Committees' (3L3) in May 2007. The '3 Level 3 Committees' are the Committee of European Banking Supervisors (CEBS), the Committee of European Securities Supervisors (CESR) and the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS). The conclusions of this work confirmed that ' differences between distribution [and disclosure] rules applicable to the different substitute products are widely acknowledged. The most frequently mentioned differences are related to authorisation and market access, approval of marketing and advertising material, and scope and form of the information to be supplied …The reasons for these differences can be found in the Directives themselves, which did not follow the trend toward increasing similarity between the financial characteristics of substitute products'. In response to this, the 3L3 found that ' … the competent authorities representing almost half of the Member States did not consider these differences as a regulatory concern, because a large number of them supplemented the Directives with national rules aiming at bringing distribution rules closer .'[25]

The '3 Level 3 Committees' are the Committee of European Banking Supervisors (CEBS), the Committee of European Securities Supervisors (CESR) and the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS).

The approaches taken at national level differ significantly between Member States. In some Member States, the provisions of MiFID have been applied to business that does not fall within scope at European level. Several Member States have also mandated additional disclosure documents, often in the form of a simplified information sheet; and some have applied a harmonised conduct of business regime to all distributors of packaged retail investment products. Detailed examples of national approaches can be found in Annex 1. In other cases, the concerns of national regulators have been translated into explicit demands for the industries concerned to deliver the necessary improvements through self-regulatory measures. This is the case in Germany, where self-regulation is already in place for retail structured securities in the form of a code of conduct. Issuers have voluntarily committed themselves to transparency and disclosure in various respects, notably with regard to product information. Codes have also been instituted in other sectors and Member States; and in some cases on a pan-European basis.[26]

In other cases, the concerns of national regulators have been translated into explicit demands for the industries concerned to deliver the necessary improvements through self-regulatory measures. This is the case in Germany, where self-regulation is already in place for retail structured securities in the form of a code of conduct. Issuers have voluntarily committed themselves to transparency and disclosure in various respects, notably with regard to product information. Codes have also been instituted in other sectors and Member States; and in some cases on a pan-European basis.

While national approaches may to some extent constitute an effective response to gaps and weaknesses in Community law at national level, their effect has been to increase the divergence in national rules even in areas in which European legislation applies. This is not necessarily problematic, in that the applicable European directives explicitly provide the flexibility for national authorities to fill gaps and to tailor European rules to the reality of domestic markets. However, divergent national approaches to disclosure rules and the regulation of intermediaries would increase costs for market operators distributing products in multiple Member States and are a potential source of legal uncertainty for originators/distributors and investors operating in multiple markets.

To what extent are these barriers likely to be material? At present, the aggregate level of cross-border business in packaged retail investment products varies considerably between product types. At one end of the spectrum, around 20% of UCITS funds are sold on a cross-border basis using the product passport provided by the UCITS Directive. Indeed, growth in cross-border net sales has outpaced domestic sales in recent years. Note however that this figure is not adjusted for so-called 'roundtripping' – where for tax reasons a firm in one Member State may domicile funds in another, creating matching cross-border flows between the two Member States without any authentic cross-border retail business being conducted from the investor's perspective. Cross-border trade in life insurance products and structured securities is much less developed. Data for unit-linked life insurance policies specifically are not available but for life insurance more broadly, only Luxembourg, Irish and British insurers receive a significant proportion of life premia from abroad (91%, 36% and 10% of total premia respectively in 2005). Data are not available on the cross-border sales of retail structured securities; anecdotal evidence suggests that cross-border sales are negligible in the EU.[27]

Note however that this figure is not adjusted for so-called 'roundtripping' – where for tax reasons a firm in one Member State may domicile funds in another, creating matching cross-border flows between the two Member States without any authentic cross-border retail business being conducted from the investor's perspective.

These patterns are consistent with trends observed in markets for retail financial services more broadly. Commission surveys suggest that only 1% of EU consumers currently buy financial services cross-border at a distance. http://ec.europa.eu/consumers/cons_int/fina_serv/cons_experiences/report_eurobarometer63-2_en.pdf , p.39. Despite the growth of distribution channels that facilitate the cross-border sale of retail financial service provision (notably, the internet), consumers still prefer to buy products distributed through local branches, subsidiaries and intermediaries. To the extent that it occurs, access to non-domestic markets is typically achieved through establishment or the merger of service providers, rather than cross-border purchases from a foreign provider.[28]

http://ec.europa.eu/consumers/cons_int/fina_serv/cons_experiences/report_eurobarometer63-2_en.pdf , p.39.

Why has cross-border trade not grown more rapidly for packaged retail investment products? In the case of unit-linked life insurance products, different approaches to contract law and claims settlement, as well as differences in taxation systems represent a significant barrier. It is less clear why retail structured securities, which benefit from a passport under the Prospectus Directive, are not sold more extensively on a cross-border basis. The answers appear to lie both in differences in tax treatment and in cultural preferences, in particular preferences for familiar, nationally-branded products and originators/distributors. These factors help to explain not only the existence of barriers to cross-border trade but also why there are marked differences in the structure of national markets, in terms of the relative popularity of particular products and in the way in which they are sold.

It is difficult to be precise about the role that regulatory differences play in the continued fragmentation of markets for packaged retail investment products. However, differences in national rules on disclosures and distribution are likely to result in additional costs for market operators distributing products in multiple Member States. For example, they may be obliged to produce different disclosure documents for identical products, even when the products are harmonised at European level and sold under a European passport. Divergent national approaches may also be a source of legal uncertainty for both distributors and investors. There is some evidence that producers do perceive divergent regulatory provisions as a barrier to cross-border activity, For example, from the review of the Distance Marketing of Financial Services Directive and feedback on the implementation of the UCITS Simplified Prospectus. although there is no indication that cross-national differences in regulation affect consumer decision making between nationally- and internationally-sourced products. This would only be a factor when services are distributed cross-border. When services are provided by a foreign originator or distributor established in the same Member State as the consumer , this would not be an issue, since the 'host' rules would apply.[29][30]

For example, from the review of the Distance Marketing of Financial Services Directive and feedback on the implementation of the UCITS Simplified Prospectus.

This would only be a factor when services are distributed cross-border. When services are provided by a foreign originator or distributor established in the same Member State as the consumer , this would not be an issue, since the 'host' rules would apply.

It is important to note, however, that consistency in disclosure and distribution rules would not in itself create the conditions for products to be offered on a cross-border basis in the same way as those products currently subject to a European passport. Differences in the regulation of products and their managers may also act as a significant barrier in this regard. Notwithstanding this important caveat, it is not unreasonable to assert that divergence in rules resulting from variegated national responses to the regulatory patchwork at European level is not conducive to the further development of cross-border trade in these sectors.

However, it is important to recall that, even in predominantly local markets, disclosure rules and regulation of intermediaries in many sectors flow directly from the implementation of Community law. Member State actions are constrained to a greater or lesser extent by Community law, whether that law is minimum or maximum harmonising, and the differences in approach within Community law (e.g. between MiFID, the Prospectus Directive, UCITS, the IMD and the CLD) inevitably lead to complicated regulatory patchworks at the Member State level reflecting the complexity at the European level. As a result, variations and gaps in effective standards at the local level are in part a consequence of the European patchwork itself, and cannot be seen as solely reactions to local market problems. This argues in favour of a European response to the problems identified as a core part of addressing local market problems, irrespective of other responses at local level. The form that this European response might take is analysed in the options section below.

3.3. How would the problem evolve without further action?

Taking no action at the European level to address the above problems means that they would be likely to persist. It does not, however, imply that the regulatory environment would remain unchanged or that the problems themselves would remain static. Indeed, the financial crisis has exposed the weaknesses in the current framework and is likely to increase the impetus for action at national and European levels in order to rebuild investor confidence.

It is reasonable to assume that some Member States may take further action. This may have a beneficial impact with respect to investor protection and the level playing field within the Member States in question. However, it would also lead to further divergence of regulatory approaches across Member States, thereby potentially impeding market cross-border business and further complicating the legislative landscape, while, as noted above, certain inconsistencies cannot be addressed effectively at Member State level as they relate to inconsistencies in Community law. Also, it is unlikely that all Member States would take unilateral action, leaving some markets without adequate regulation.

Some self-regulatory initiatives can also be expected to emerge without further stimulus from the EU. There is some evidence that the industry is acting to address some of the weaknesses identified above. For example, in the insurance sector, BIPAR and FECIF/AILO have recently adopted codes of conduct that are relevant to some of the problems identified; and a taskforce dedicated to enhancing product disclosures has been created within the European Banking Federation.

At EU level, in the absence of new initiatives, existing workstreams may contribute to mitigating the problems in certain sectors and for certain products. These include:

· Development of Key Investor Information for UCITS;

· Review of the Prospectus Directive, and possibly other sectoral directives;

· Work on improving financial education, in conjunction with Member States;

· Reviews of DMD and IMD; and

· Ongoing work on Non-Harmonised Funds.

More generally, the financial crisis has been the catalyst for a wider package of regulatory measures to enhance the stability of the financial system and to rebuild confidence in financial institutions and products, and there are likely to be continued developments in this area. While announced measures have focused largely on prudential and supervisory issues, these will impact on investor protection, since investors share an interest in the stability of the institutions from which they purchase financial products.

The initiatives described above would not, however, alone be able to address the weaknesses in a coherent and systematic manner. A comprehensive process of upgrading disclosures is currently envisaged only for UCITS; this may yield insights of broader application but will focus only on harmonised funds. With regard to distribution, scheduled reviews of existing sectoral directives could be used to examine some of these issues; however, without a coherent organising framework it could not be guaranteed that a level playing field and consistently high level of investor protection would result.

Without further action, therefore, it is both highly likely that the problems would remain and moreover that additional uncoordinated national action would increase the complexity of the regulatory framework, with attendant implications for the single market.

4. Subsidiarity and Legal Basis

The preceding discussion has identified a strong European dimension to the problems identified. Differences in Community law can distort market and regulatory outcomes in all Member States, irrespective of whether products are distributed on a cross-border basis. Differences in Community law thus represent a significant barrier to the implementation of a consistent approach to disclosure and distribution between sectors at national level. For those products sold on a cross-border basis, investor protection concerns cannot be tackled effectively at Member State level. Uncoordinated national responses would also risk encumbering the development of the single market in these products.

The legal basis for action in this field is found in the following Treaty provisions. According to Article 3 of the EC Treaty, an internal market is characterised by the abolition of obstacles to the free movement of goods, persons, services, and capital. Article 14 further states that the internal market shall comprise an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured in accordance with the provisions of the Treaty. Any further action as a follow-up to the Communication is likely to be based on Art. 211 of the EC Treaty (if in the form of a Recommendation) or Article 95 of the EC Treaty (if in the form of legislation).

5. Objectives

The overarching objective of this work is to promote the efficient allocation of resources through:

· A high and consistent level of investor protection embodied in Community law;

· A level playing field for the originators and distributors of retail investment products; and

· Increased efficiency in cross-border business.

The first and second of these should be seen in tandem at the heart of this work: the level playing field with respect to disclosure and distribution rules is to be achieved at a high level of investor protection. Given the predominantly local nature of certain parts of the retail markets, the third objective is subsidiary to the first two. It is, however, an important consideration for those products that are sold on a cross-border basis; and for those for which this could potentially be the case.

5.1. A high and consistent level of investor protection

General objective

A consistently high level of investor protection across all packaged retail investment products is the key objective, thereby creating an environment in which retail investors are provided with the information they need to take effective decisions and are treated fairly in the sales and advice process by product originators and distributors.

This objective does not necessarily imply total uniformity in the information that should be provided or in the way in which products are sold. Differences in the relationship between the investor and the originator and the varying nature of the investment propositions imply a need for flexibility.

However, to the greatest extent possible, an investor surveying the available options should be able to compare the key characteristics of the products offered - which is a matter both of the type of information that is provided and the way in which it is presented. This implies seeking, where relevant, common formats that allow for comparison of key characteristics and which are developed so as to take into account typical consumer behaviour. Investors should be able to be confident that the quality of service is comparable in each case.

This objective must be qualified by the observation that while improvements in disclosure and the regulation of intermediaries can help to create the conditions for effective decision-making by retail investors, they cannot eliminate the possibility of poor decision-making and hence investor detriment. In particular, the quality of investor decision making will depend greatly on the willingness and ability of consumers to understand and process the information and advice received. Improvements in financial education will thus be an essential complement to this work.

Specific objectives

To lay the foundation in European rules on pre-contractual disclosure and the regulation of intermediaries for retail investors to make informed and appropriate investment decisions.

To achieve this, a retail investor should be able to expect a consistently high level of product disclosure and fair treatment by distributors irrespective of the product type they select, or the distribution channel through which they obtain the product.

The benchmark for this assessment can be expressed in the form of a set of core 'principles' that define outcomes to be delivered by Community law and applied to the full spectrum of packaged retail investment products and distribution channels. The ideas embedded in these principles are not novel; they are drawn from widely accepted benchmarks found in international standards and in European and national law. Further work will be required to fine-tune these principles as appropriate.

Product disclosures should be fair, clear and not misleading, even for less experienced retail investors.

They should contain all information necessary to take an informed investment decision (such as information about performance and risks, charges, guarantees and how the product functions, for instance fixed maturity dates). They should be presented in a format appropriate for a retail investor and how that investor is likely to use the information, and to the greatest extent possible they should be designed consistently across different products to allow for comparisons between the products.

The format should be as short and simple as is possible, and tested with investors to ensure it works as intended.

The disclosures should be provided to the investor in a timely fashion so as to be capable of influencing the decision as to whether to buy an investment.

Any associated marketing communications should be fair, clear and not misleading, and should be clearly distinguished from the mandatory disclosures and should indicate where such disclosures can be obtained (where relevant). They should not undermine mandatory disclosures.

Selling practices should be focused on the fair treatment of the investor.

When an investor receives investment advice, the advisor should undertake best efforts to ensure any products sold correspond to the profile and the needs of the investor, and should ensure that the investor is aware of the nature of the service being provided by the advisor, included remuneration arrangements in relation to the service.

If a product is sold without advice, the responsibility of the intermediary and risks for the investor should be made clear before proceeding with the provision of services. Also in this case, some assessment concerning the adequacy of the product to investors' needs may be required.

All necessary steps should be taken to prevent conflicts of interest from adversely affecting clients. Such conflicts should be avoided if possible and, if not possible, they should be identified, managed and, where appropriate, disclosed in a way investors can understand. Links between manufacturers and distributors in the form of ownership stakes should be disclosed to the end investor. Links in the form of remuneration for product sales should be disclosed and should be assessed in the perspective of client interests.

Manufacturers should provide distributors with the necessary product information related to the product and distributors should clearly understand the product and ensure investors receive relevant product information. Manufacturers also would bear some responsibility in relation to the generic suitability of products which they distribute into the retail market.

5.2. A level playing field for the originators and distributors of packaged retail investment products

General objective

The second objective is to achieve a level playing field for all types of packaged retail investment product with respect to disclosure and distribution rules. Consistency in these requirements would already help to ensure that competition between products takes place on a transparent and fair basis. This will help to ensure that markets develop on the basis of the quality of the products and their compatibility with consumer needs, not by a lack of transparency or of selling disciplines with respect to certain products. Product diversity is potentially beneficial for the retail investors and as such this objective does not imply a regulatory preference for one product type over another.

As discussed earlier, it is important to recognise in this context that there are other elements of the regulatory 'playing field' that impact on competition between products but which are not addressed in this analysis. For example, UCITS managers are subject to prescriptive product regulation that limits the range of financial assets in which they can invest, their use of borrowed funds, redeemability etc. These restrictions are not generally found in other sectors. Other non-regulatory factors, most notably features of domestic tax systems, will also impact on competition between product types.

Specific objective

More specifically, the objective is to achieve a coherent overall approach to disclosure and distribution provisions in Community law, thereby achieving a level playing field with respect to these rules.

This objective must be seen in the context of the first objective: the level playing field should be set at a consistently high level of investor protection for all packaged retail investor protection .

5.3. Increased efficiency in cross-border business

General objective

Markets for retail investment products are largely segmented along national lines. Further integration of these markets through an increase in cross-border trade could deliver efficiency benefits for both producers and consumers. In principle, a divergence in disclosure rules and distribution rules between Member States may constitute a barrier to the cross-border provision of services. The objective is therefore to remove obstacles to cross-border trade resulting from divergence in national approaches to disclosure and distribution regulation.

Specific objective

To promote more consistent national approaches to disclosure and distribution rules by ensuring that Community law provides a coherent approach to disclosure and distribution regulation.

An important caveat to this objective is that, as discussed above and in the Green Paper on Retail Financial Services, there is reason to believe that certain legal and fiscal barriers, as well as behavioural preference for products provided locally (and face-to-face), represent a more significant barrier to cross-border trade than differences in disclosure and distribution regulation. Moreover, greater harmonisation of disclosure and distribution regulation at European level will not in itself provide cross-border marketing opportunities equivalent to a product passport. Other differences in approach, for example with respect to product regulation, would potentially remain.

6. Options

This section considers the efficiency and effectiveness of alternative policy options in the area of pre-contractual disclosures and selling practices, as means to achieving the three objectives outlined above:

· a high and consistent level of investor protection across all products and distribution channels, including those not currently subject to EU disclosure and distribution rules;

· a level playing field for all types of retail investment product, including their distribution; and

· a strengthened single market in packaged retail investment products.

The multitude of factors involved means that the policy options analysed here cannot alone guarantee the three objectives above, although they can contribute to their achievement. In particular, while the analysis below treats options separately so as to clarify their incremental impact, in general terms the options should not be considered to be mutually exclusive – for instance, coordinated regulatory and supervisory action at the European and national levels could provide the framework for a consistent overall approach, to be accompanied and supported by self-regulatory activity (e.g. developing best practices for the use of plain language).

In the following analysis we address pre-contractual disclosures and selling practices separately. However, we think it likely that there would be synergies between these two areas – a package of options relating to pre-contractual disclosures as well as selling practices might have greater benefits than either on its own.

6.1. Pre-contractual product disclosures

6.1.1. Identification of options

Our analysis is that the options for addressing pre-contractual product disclosures broadly sit on a scale from a base-line of no change to the highest level of harmonisation at the European level. To give shape to the analysis, we have focused on the following: no policy change; Commission-promoted self-regulation; a mandate to the Level 3 committees to promote supervisory convergence; a Commission recommendation to implement principles through national regulation; or EU-level legislative action to harmonise requirements where appropriate across products and channels. As stated these options are not mutually exclusive, the first notwithstanding, and may be effectively combined. An assessment of the exact nature of any future measures does not form part of this Impact Assessment; any specific follow up actions would be accompanied by a separate impact assessment which might address the optimal combination of initiatives necessary for achieving the objectives.

Table 3 : Identification of options for pre-contractual product disclosures

Option|Description of option|

1. No policy change|As described already in section 3.3., without policy action at EU level neither foreseeable policy change at Member State level, nor parallel pre-existing or foreseeable EU work flows would address the problems effectively. Any potential action at national level could further aggravate cross-border inconsistencies, while existing inconsistencies at EU level would persist, undermining the effectiveness of action at national level. This no policy change scenario is used as the baseline for the assessment of other policy options.|

2. Commission sponsored self-regulation|Under this option market sectors involved – both originators and distributors – would be invited to develop pre-contractual disclosures in compliance with a common set of principles. Market participants would be free to develop their own solutions, though with a steer from the Commission. No legislative changes would be made at European level, so differences that can be traced to Community law would remain, while this option would not directly tackle differences in laws between Member States themselves, where they have already acted to address the issues raised in this assessment. This could be on the basis that the Commission would review the approach should outcomes turn out to be ineffective, so as to encourage market participant engagement.|

3. Mandate to Level 3 committees to promote supervisory convergence|The committees of regulators could be invited to work together to identify 'best practices' in pre-contractual disclosure and to disseminate these to all Member States. Peer pressure could be used to promote agreement on and respect for either high-level principles or more concrete disclosure solutions. As with option 2, no legislative changes would be made at European level.|

4. Commission Recommendation to implement principles through national regulation|A Recommendation could build upon relevant provisions (e.g. in MiFID, CLD and IMD) to guide Member State implementations of these, for instance to clarify what would constitute compliance with existing disclosure obligations. Member States could also be encouraged to introduce requirements in national law for product originators to develop compliant disclosure documents. As with option 2, no legislative changes would be made at European level; a Recommendation would offer the Commission's opinion in relation to existing Community legislation. |

5. EU-level legislative action|EU-level legislative action could take a variety of forms, running from a more limited removal of EU-level impediments to best practice and provision of a high-level framework of common principles, to detailed requirements setting out the content and form of harmonised pre-contractual disclosures across all relevant products. While we cannot assess the most appropriate form of possible legislative action at this stage, any action would need to take account of existing provisions in EU law, both in sectoral and cross-cutting directives. In principle, the legislative objectives could be achieved either by a new stand-alone legislative instrument or by adjustments to existing EU legislation. In either case, the legislation could be embedded in the Lamfalussy framework, with general principles established at Level 1 and detail added at Level 2. See: http://ec.europa.eu/internal_market/finances/committees/index_en.htm#committee for further information on the Lamfalussy framework. See: http://ec.europa.eu/internal_market/finances/committees/index_en.htm#committee for further information on the Lamfalussy framework.|

6.1.2. Analysis of costs and benefits

Our detailed analysis of the options can be found in Annex 2, but we would like to make here a few general remarks on cost and benefit drivers.

Costs

The incremental compliance and administrative costs of designing and producing new disclosure documents are likely to be similar irrespective of the underlying mechanism by which change has been promoted, so likely costs could be very similar across different options, at least in so far as those options effectively change industry behaviour.

· Our analysis focuses on incremental costs, i.e. those costs that firms or others would incur that can be solely (or proportionally) attributed to the impact of the policy options under analysis. These can be divided into both one-off costs of changing existing documents or developing new ones, and ongoing costs of maintaining the documents.

· Cost drivers include the design of new documents and the establishment of systems and controls for ensuring compliance, including, where relevant, the preparation of figures, whether audited or not, one-off and ongoing production and distribution costs, incremental costs in changing other documentation and websites which might cross-refer to the documents, and training costs (which may largely be related to distribution channels).

· In general terms, costs can be analysed in terms of costs for the parties directly affected by changes, costs for regulators or supervisors and other similar bodies, and less direct costs – such as changes to the quantity, quality and variety of transactions, or to market efficiency.

The balance between these cost drivers is likely to vary for the different options being analysed, depending on the amount and nature of the change required for particular market segments. The costs will also vary significantly depending on whether requirements already exist within a particular Member State and whether the new requirements entail incremental changes to pre-existing disclosures by firms or the creation of entirely new disclosures, e.g. for instruments hitherto outside the scope of requirements.

· The incremental benefit of changes for consumers in Member States that have already developed mandatory disclosure requirements aimed at addressing the issues in this paper is likely to be low, in so far as these consumers continue to shop within their home markets and in so far as the existing mandatory disclosure requirements are effective in protecting consumers.

· For these jurisdictions with pre-existing disclosure requirements, a high-level principles-based approach may offer relatively lower costs (compared to more detailed and strongly standardised requirements), particularly where the pre-existing requirements are already consistent with the high-level principles. There could well nonetheless be some compliance costs. For jurisdictions which do not have pre-existing disclosure requirements there would likely be one-off costs for national regulators or other self-regulatory bodies interpreting these principles for firms, on top of the direct costs firms would face.

· More detailed and strongly standardised requirements might reduce some costs by providing participants with ready-made solutions which do not require significant adaptation and compliance testing, though under this option all participants impacted would necessarily face costs of change.

· There are also likely to be varied impacts on supervisory costs, for instance should supervisors need to pre-authorise or otherwise develop an enhanced capability for monitoring or s