Mis-selling of financial products : marketing, sale and distribution.
Date: 2018-06-28
Institutions: Directorate-General for Internal Policies of the Union
Subjects: EU Member State, consumer protection, distributive trades, financial regulation, financial services, financial transaction, marketing, sale

STUDY 
Requested by the ECON committee 

Marketing, Sale and 
Distribution 

Mis-selling of Financial Products 

Policy Department for Economic, Scientific and Quality of Life Policies 
Author: Professor Kern ALEXANDER 
Directorate-General for Internal Policies 
PE 618.996 - June 2018 

EN 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
DIRECTORATE GENERAL FOR INTERNAL POLICIES 

POLICY DEPARTMENT A: ECONOMIC AND SCIENTIFIC POLICY 

 Mis-selling of Financial Products: 
Marketing, Sale and Distribution 

STUDY 

Abstract 

This study forms part of a series of five studies on mis-selling of financial products 
in the EU. The study reviews the EU legislative and regulatory framework for the 
marketing, sale and distribution of financial products to assess whether post-crisis 
EU regulatory reforms have met their objectives and, if not, what are the gaps 
and weaknesses in the current EU regulatory approach. The EU follows a sectoral 
approach to regulating the marketing and sale of financial products, which results 
in  segmentation  and  arbitrage  risks.  The  paper  argues  that  the  European 
Supervisory Authorities should adopt more harmonised regulatory and technical 
standards  to  reduce  these  risks  and  ensure  more  effective  enforcement  by 
Member State authorities. This document was provided by Policy Department A 
at the request of the ECON Committee. 

IP/A/ECON/2016-17 

PE 618.996 

June 2018 

EN

This  document  was  requested  by  the  European  Parliament's  Committee  on  Economic  and 
Monetary Affairs. 

AUTHOR 

Professor Kern ALEXANDER, University of Zurich 

RESPONSIBLE ADMINISTRATOR 

Stephanie HONNEFELDER 
Drazen RAKIC 
Policy Department A: Economic and Scientific Policy 
European Parliament 
B-1047 Brussels 
E-mail: Poldep-Economy-Science@ep.europa.eu 

EDITORIAL ASSISTANT 

Janetta CUJKOVA 

LINGUISTIC VERSIONS 

Original: EN 

ABOUT THE EDITOR 

Policy departments provide in-house and external expertise to support EP committees and 
other parliamentary bodies in shaping legislation and exercising democratic scrutiny over EU 
internal policies. 

To contact Policy Department A or to subscribe to its newsletter please write to: 
Poldep-Economy-Science@ep.europa.eu 

Manuscript completed in June 2018 
© European Union, 2018 

This document is available on the Internet at: 
http://www.europarl.europa.eu/studies 

DISCLAIMER 

The opinions expressed in this document are the sole responsibility of the author and do not 
necessarily represent the official position of the European Parliament. 

Reproduction  and  translation  for  non-commercial  purposes  are  authorised,  provided  the 
source is acknowledged and the publisher is given prior notice and sent a copy. 

© Cover page image used under the license from Shutterstock.com 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Mis-selling of Financial Products: Marketing, Sale and Distribution 

CONTENTS 

LIST OF ABBREVIATIONS 

EXECUTIVE SUMMARY 

4 

5 

  PRE-CRISIS EU REGULATORY APPROACH TO FINANCIAL PRODUCTS  8 

1.1.  Information Disclosure Paradigm 

1.2.  Pre-Crisis EU Regulatory Framework 

1.3.  UK mis-selling 

1.4.  Pre-crisis EU regulatory reforms shortcomings 

1.5.  Crisis results in further changes to MiFID 

  POST-CRISIS REGULATORY APPROACH - MIFID II/MIFIR 

2.1.  A Change in Focus 

2.2.  MiFID II/MiFIR 

2.3.  MiFID II Shortcomings 

  OTHER EU LEGISLATION: UCITS IV/V, AIFMD, IDD 

3.1.  UCITS IV (2009/65/EC) and UCITS V (2014/91/EU) 

3.2.  UCITS VI? 

3.3.  AIFMD (2011/61/EU) 

3.4.  General gaps of the current framework 

  THE AGENCY DESIGN OF FINANCIAL REGULATION 

  ENDOWMENT INSURANCE PRODUCTS 

  CLOSET INDEXING 

6.1.  Investigations of Closet Trackers 

  CONCLUSION 

REFERENCES 

8 

9 

12 

14 

15 

16 

16 

16 

19 

22 

22 

22 

23 

24 

25 

27 

29 

29 

31 

33 

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Policy Department A: Economic and Scientific Policy 

LIST OF ABBREVIATIONS 

AIFMD  Alternative Investment Fund Managers Directive 

AMF  Autorité des Marchés Financiers (France) 

BaFin  Bundesanstalt für Finanzdienstleistungsaufsicht (Germany) 

BBA  British Bankers Association 

CCA  Consumer Credit Act (UK) 

CSSF  Commission de Surveillance du Secteur Financier (Luxembourg) 

ESMA  European Securities and Markets Authority 

FCA  Financial Conduct Authority (UK) 

FOS  Financial Ombudsman Service (UK) 

FSA  Financial Supervisory Authority 

FSAP  Financial Services Action Plan 

FSMA  Financial Services and Markets Act 2000 (UK) 

IBIPs  Insurance-Based Investment Products 

ICBR  Intermediary Conduct of Business Rules (UK) 

IDD  Insurance Distribution Directive 

IMD  Insurance Mediation Directive 

KID   Key Investor Document (related to the scope of PRIIPs) 

KIID  Key Investor Information Document (related to the scope of UCITS IV) 

KYC  Know-Your-Customer 

MAR  Market Abuse Regulation 

MiFID/R  Markets in Financial Instruments Directive/Regulation 

MTF  Multilateral Trading Facility 

OTC  Over-The-Counter 

OTF  Organised Trading Facility 

PPI  Payment Protection Insurance 

PRIIPs  Packaged Retail and Insurance-based Investment Products 

RDR  Retail Distribution Review (UK) 

UCITS  Undertakings for Collective Investment of Transferable Securities 

UCPD  Unfair Commercial Practices Directive 

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Mis-selling of Financial Products: Marketing, Sale and Distribution 

EXECUTIVE SUMMARY 

The  pre-crisis  EU  approach  to  regulating  the  marketing,  sale  and  distribution  of  financial 
products was based on the notion that the disclosure of minimum information regarding the 
costs, charges and risks of financial products was adequate for retail customers to assess the 
expected returns and risks of different financial products. The regulatory focus on mandatory 
disclosure  of  information  imposed  few,  if  any,  ex  ante  limits  on  the  offer  and  design  of 
financial products. There were largely no constraints on selling processes and on the design 
and distribution of financial products except for the general and ambiguous requirement that 
all  marketing  communication  was  ‘fair,  clear  and  not  misleading’.  Under  the  law  of  most 
Member States, there were few, if any, legal remedies to be used against financial institutions 
unless  it  could  be  shown  that  they  engaged  in  affirmative  misrepresentations  or  outright 
fraud. Banks and other intermediaries were encouraged to know their customers to support 
their business strategy of selling more complex financial products and investments designed 
to  allow  their  customers  to  benefit  from  the  potential  upside  gains  of  liberalised  financial 
markets  but  exposing  them  as  well  to  the  downside  risks  of  volatile  and  unpredictable 
financial markets.   

The  crisis  of  2007-2008  demonstrated  that  many  retail,  professional  and  wholesale 
institutional  investors  had  failed  to  understand  the  risks  associated  with  complex  financial 
products and that investor reliance on mandatory regulatory disclosure was inadequate for 
investors  to  understand  and  assess  the  relevant  risks.  Huge  losses  by  large  numbers  of 
customers and professional investors were attributed in part to cognitive heuristics, that is, 
reliance on ‘rule of thumb’ approaches to deciding which products to purchase, rather than 
formal techniques of risk assessment. Moreover, bank and investment firm governance was 
too weak to address the incentives of brokers and customer advisers who were incentivised 
to promote ‘tied’ products that paid disproportionately high commissions that were usually 
not disclosed to the customer.  

The  European  Commission  issued  a  Decision  in  2011  that  concluded  that  systematic  mis-
selling of financial products by financial institutions and the massive losses  of institutional 
and  retail  investors  could  be  attributed  to  inadequate  disclosure  of  the  underlying  costs, 
charges and risks of products and the incentives of firms to design unsuitable products for 
their customers, and customers’ behavioural biases and financial illiteracy. The Commission’s 
Decision concluded that the efficacy of disclosure requirements was very much dependent on 
the context of the markets in which decisions were made. The result was that pre- and post-
crisis, despite the adoption of extensive regulatory reforms, massive mis-selling of financial 
products – both to retail and sophisticated investors – was pervasive across financial markets.  

This  study  aims  to  review  the  EU  legislative  and  regulatory  framework  for  the  marketing, 
sale and distribution of financial products to assess whether post-crisis EU regulatory reforms 
have met their objectives and, if not, what are the gaps and weaknesses in the current EU 
regulatory approach. The paper will analyse the Market in Financial Instruments Directive II 
(MiFID II) regarding how it regulates the sale and distribution of financial products and its 
rules concerning conflict of interests and disclosure of costs and charges to customers. It will 
also assess the extent to which MiFID II provides a comprehensive regime governing the sale 
and  distribution  of  financial  products  and  the  degree  of  segmentation  risk  in  the  market 
because MiFID II does not cover a wide array of other investment products, such as certain 
securitised  investments  and  insurance-based  investment  products,  governed  by  other  EU 
legislation.  

The  paper  will  also  consider  how  other  EU  legislation  regulates  the  sale  of  financial  and 
investment  fund  products,  such  as  the  Undertakings  for  Collective  Investment  in 
Transferrable Securities (UCITS) and the Alternative Investment Fund Management Directive 

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Policy Department A: Economic and Scientific Policy 

(AIFMD).  The  paper  also  considers  the  regulation  of  insurance-based  investment  products 
(IBIPs) under EU insurance legislation and the sale of endowment products that are linked 
to underlying financial instruments. The paper also reviews recent regulatory developments 
regarding the supervision of closet index funds and what risks they pose to investors.  

The paper’s findings are that because the EU follows a sectoral approach to regulating the 
sale and distribution of financial products, there are different regulatory standards across 
the banking, asset management, insurance and alternative investment fund sectors 
governing the sale and distribution of these products This creates segmentation risks 
because the risks associated with these products are subject to different legal requirements 
and are regulated by different sectoral regulatory bodies who apply different standards and 
conduct different risk assessments. For example, depending on whether a financial product 
is classified as a MiFID II investment or an insurance-based investment product covered by 
the Insurance Mediation Directive will determine what type of information has to be disclosed 
about the product’s risks and what type of compensation can be paid to those responsible for 
issuing and selling the product. As a result, financial products that share substantially similar 
economic characteristics and risk-return features are treated significantly different in terms 
of  disclosure  requirements,  conflict  of  interest  rules  in  their  promotion  and  sale,  and  the 
regulator’s product intervention powers. 

This  paper  argues  that  the  EU  regulation  of  retail  financial  products  and  related 
investment  services  suffers  from  segmentation  risks  and  regulatory  arbitrage 
opportunities for financial institutions to design risky financial products that attract 
minimum  regulatory  protections.  Rather  than  applying  similar  regulatory  standards  to 
these  products,  the  EU  legislative  and  regulatory  framework  treats  these  products  with 
similar risk features significantly different in terms of regulatory requirements and therefore 
creates an uneven regulatory playing field resulting in segmentation risks between different 
financial sectors in which similar risks in similar financial products are regulated differently 
in different financial sectors, even though these products pose the same (or similar) risks. 
This  situation  can  also  lead  financial  institutions  to  engage  in  regulatory  arbitrage  as  the 
design of investments is driven mainly by regulatory compliance considerations, rather than 
by  economic  factors,  such  as  the  risk  adjusted  return  for  customers.  EU  draft  legislation 
(UCITS VI)  shows  that  progress  is  possible  in  this  area.  The  paper  suggests  that  EU 
policymakers should call for an alignment in requirements for the marketing, sale and 
distribution (along with similar product intervention powers) of all financial products sold in 
the EU to retail customers. This would require revising the existing EU laws governing the 
sale and distribution of financial and investment products across the  different EU financial 
sectors. It would also require that the three European Supervisory Authorities (ESAs) work 
closely  together  in  implementing  existing  and  new  legislation  to  address  regulatory  gaps, 
segmentation risks, and arbitrage opportunities. The Joint Committee of the European 
Supervisory Authorities could facilitate enhanced coordination between the three 
ESAs to adopt more harmonised regulatory and technical standards for disclosing 
the costs, charges and risk metrics of all retail financial products and for adopting 
more harmonised remuneration  rules  across financial sectors  for the  distribution 
and sale of products by independent advisers.      

The  paper,  however,  concludes  that  implementing  a  more  harmonised  legislative  and 
regulatory  framework  governing  the  marketing,  sale  and  distribution  of  financial  products 
was not achieved under MiFID I and will pose serious challenges for Member State regulatory 
authorities under MiFID II and other EU legislation governing the sale of financial products. 
Segmentation  risks  and  regulatory  arbitrage  will  be  difficult  to  eradicate  in  the  financial 
product  markets  especially  because  of  the  potential  for  banks  and  other  financial  firms  to 
engage in product innovation, particularly the design of different products and investments 
with  different  risk  characteristics.  Also,  reforms  to  promote  a  more  harmonised  system  of 

6 

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Mis-selling of Financial Products: Marketing, Sale and Distribution 

laws and regulations governing the sale and distribution of financial products will be difficult 
to  address  so  long  as  the  EU  continues  to  follow  a  sectoral  approach  to  regulating  these 
products.  Finally,  the  paper  also  points  out  related  regulatory  concerns  in  the  asset 
management industry concerning closet-index funds that are charging customers for 
active  asset  management  but  instead  are  only  linking  their  assets  to  the  performance  of 
index funds. The paper raises the question of whether this should be classified as a form of 
misrepresentation and discusses recent regulatory investigations.  

Finally,  the  paper  considers  what  type  of  institutional  structure  of  financial  regulation  is 
appropriate for the supervision of consumer financial protection.  After reviewing the main 
supervisory models – Functional, Institutional, Integrated, and Twin Peaks – it recommends 
that the institutional design of financial regulation within EU Member States should 
require that a consumer financial protection authority should be created along the 
lines  of  the  US  Consumer  Financial  Protection  Bureau  and  that  it  should  be 
institutionally  separate  from  the  central  bank  or  other  prudential  regulator 
responsible  for  prudential  supervision.  At  present,  however,  in  most  EU  states,  the 
prudential supervisor is typically also responsible for consumer financial protection. Member 
States should be required or strongly encouraged to restructure financial supervision at the 
Member  State  level  so  that  the  consumer  financial  protection  agency  is  institutionally 
independent from the bank regulator.   

This paper has also considered and reviewed the European Commission’s draft proposals for 
a ’New Deal for Consumers‘ package that was proposed in April 2018 just after this paper 
was  finalised.  The  Commission’s  draft  legislation  is  relevant  to  retail  financial  services 
regulation  in  the  EU  because  it  would  create  a  new  collective  redress  regime  where  EU 
consumer  law,  including  MiFID  II,  UCITS,  PRIPS  and  IDD,  has  been  violated.  The 
Commission’s  proposals  include  a  new  draft  Directive  on  representative  actions  for  the 
protection  of  the  collective  interests  of  consumers  in  which  ’qualified  entities‘  would  be 
authorised to bring a representative action before a Member State court or administrative 
authority on behalf of classes of consumers who have suffered losses for a trader’s violation 
of  EU  consumer  protections  laws.  If  the  trader  is  found  liable,  it  would  be  required  to 
compensate  the  consumers  who  suffered  losses  or  take  other  redress  measures  to  make 
them whole again. Redress for retail customers of banking or financial institutions would be 
available where the bank or financial services firm was shown to have breached prescribed 
EU  financial  services  legislation.  This  paper’s  welcomes  the  Commission’s  draft  Directive 
because it would provide financial consumers with an additional procedural avenue to have 
their rights asserted under EU financial services law and to compensate them for losses and 
to provide any other adequate relief. The paper concludes however that such legislation will 
not  be  effective  unless  it  is  accompanied  by  substantive  reform  of  EU  financial  services 
legislation  (MiFID  II,  UCITS,  PRIPs  and  IDD)  to  reduce  segmentation  risks  and  regulatory 
arbitrage between the different pieces of EU financial consumer legislation and to ensure that 
an independent regulatory authority to act on behalf of consumers (including to bring claims 
on their behalf) is created in each Member State.  Such an independent regulatory authority 
could potentially work with the qualified entities proposed in the Commission’s draft Directive. 
For  the  Commission’s  draft  Directive  on  representative  actions  to  succeed  and  become  an 
effective mechanism for financial consumers to vindicate their rights under EU law, it must 
be accompanied by legal and regulatory reform on other fronts as discussed in this paper.  

PE 618.996 

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Policy Department A: Economic and Scientific Policy 

  PRE-CRISIS EU REGULATORY APPROACH TO FINANCIAL 

PRODUCTS 

KEY FINDINGS 

The  crisis  of  2007-2008  demonstrated  that  many  retail,  professional  and  wholesale 
institutional investors had failed to understand the risks associated with complex financial 
products and that investor reliance on mandatory regulatory disclosure was inadequate 
for investors to understand and assess the relevant risks. Moreover, bank and investment 
firm governance was weak and did not address the incentives of brokers and customer 
advisers  who  were  incentivised  to  promote  excessively  risky  products  that  were 
unsuitable for their clients. Despite the adoption of extensive regulatory reforms following 
the crisis, massive mis-selling episodes continued to occur in many EU Member States. 
Although the post-crisis regulatory reforms addressed some of the risks associated with 
persistent mis-selling, significant weaknesses in the EU regulatory regime remain due to 
gaps  in  implementation,  supervision  and  enforcement,  resulting  in  different  levels  of 
investor protection across the EU, thereby increasing market segmentation. 

Information Disclosure Paradigm 

1.1. 
Prior  to  the  crisis,  investors  were  deemed  to  be  ’well-informed‘,  rational,  and  wealth 
maximising. The rational investor was a customer of a bank, investment firm, or insurance 
firm  who  was  empowered  by  the  information  that  was  disclosed  by  financial 
intermediaries  and  issuers  to  make  efficient  and  wealth  maximising  investments.  Most 
consumer or retail financial regulation was based on the assumptions of neo-liberal classical 
theory  that  held  that  investors  are  rational  agents  who  seek  to  maximise  their  wealth  by 
allocating  their  investments  according  to  their  risk  appetites  to  obtain  the  highest  risk-
adjusted  return1.  Based  on  this  assumption  of  the  rational  wealth  maximising  investor, 
policymakers designed a model of retail or consumer financial regulation that was based on 
more and relevant information disclosure for investors to make their own rational calculations 
and assessments of risk to fit their unique circumstance. The regulator would only intervene 
in cases of significant consumer injury2. Despite widespread dissemination of information to 
the  customers  of  financial  institutions,  there  were  many  instances  of  systematic  and 
intentional mis-selling of financial products and related investment services by institutions 
and their brokers in the 1990s and 2000s. Systematic and widespread mis-selling continued 
post crisis despite the adoption of extensive international and EU regulatory reforms.  

Systematic and widespread mis-selling led policymakers and regulators across the EU and in 
third  countries  to  adopt  alternative  theories  of  regulation  that  are  based  on  behavioural 
finance  models  that  emphasise  the  bounded  rationality  or  capability  barriers  of  investors. 
These models hold that the rationality of investors is bounded because of the complexity and 
inherent asymmetric information barriers in financial markets and that investors often do not 

1   Kingsford Smith and Dixon, p. 707. Similarly, in competition regulation, the notion of a rational and informed 
consumer  who  maximises  its  utility  by  seeking  the  lowest  most  competitively  priced  product  dominates  the 
assumptions of policymakers and jurists. 

2   According to the traditional law and economics approach, investors can determine their product of preference if 
provided  with  information  on  the  price,  quality  and  other  factors  of  products.  The  availability  of  information 
creates  an  incentive  for  sellers  to  improve  their  products,  leading  to  competition,  consumer  welfare  and  an 
efficient economy. See Beales et al, 1981, p.492. Accordingly, the US Federal Trade Commission stated: “It is a 
basic  tenet  of  our  economic  system  that  information  in  the  hands  of  consumers  facilitates  rational  purchase 
decisions.” See FTC, 1979. 

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Mis-selling of Financial Products: Marketing, Sale and Distribution 

act rationally in their best interests and are subject to irrational behaviour, such as herding, 
that can lead to more volatile and lower investment returns over time3.  

Other regulators have emphasised the importance of financial literacy, defined as ’financial 
awareness,  knowledge,  skills,  attitude  and  behaviours  necessary  to  make  sound  financial 
decisions‘ 4.  Studies  suggest  that  financial  literacy  is  very  low  among  most  retail 
financial  customers.  Recent  mis-selling  scandals  demonstrated  that  many  retail, 
professional  and  institutional  investors  had  failed  to  understand  the  risks  associated  with 
complex financial products and that investor reliance on mandatory regulatory disclosure was 
inadequate  for  investors  to  understand  and  assess  the  relevant  risks.  Substantial  losses 
incurred by large numbers of customers and professional investors were attributed in part to 
cognitive  heuristics,  that  is,  reliance  on  ‘rule  of  thumb’  approaches  to  deciding  which 
products to purchase, rather than formal techniques of risk assessment. Behavioural 
bias, including overconfidence, risk tolerance, social influence, framing effects (highlighting 
positive  features,  downplaying  potential  losses)  proved  to  influence  significantly  the 
investments and financial products subscribed to by many bank customers and investors. 

The  European  Commission  recognised  these  market  failings  in  a  2011  Commission  Staff 
Working  Paper  that  attributed  the  systematic  mis-selling  of  financial  products  by  financial 
institutions  and  the  massive  losses  of  institutional  and  retail  investors  to  market  failures 
connected  with  inadequate  disclosures  of  the  costs,  charges  and  risks  associated  with 
financial products, and the incentives within firms to design unsuitable products5. Chater et 
al.’s  Final  Report  to  the  European  Commission  on  Consumer  Decision-Making  in  Retail 
Investment  Services  stated  that  retail  investors  in  the  EU  struggled  to  make  optimal 
investment decisions; that they were influenced by behavioural weaknesses, and the efficacy 
of disclosure requirements was very much dependent on the context of the markets in which 
decisions were made 6. Other market failures identified by the report included retail customer 
confusion, very limited searching for information, difficulties in processing conflict of interest 
disclosure, heavy reliance on trust in investment advice7. The result was that pre- and post-
crisis, despite the adoption of extensive regulatory reforms, massive mis-selling of financial 
products- both to retail and sophisticated investors – was endemic to the markets.  

The  pre-crisis  EU  approach  to  regulating  the  marketing  of  financial  products  was  based 
primarily on a disclosure framework that imposed few, if any, ex ante limits on the offer and 
design  of  investment  products.  Moreover,  there  were  largely  no  constraints  on  selling 
processes  and  how  products  were  distributed.  Banks  and  other  intermediaries  were 
encouraged to know their customers to support their business strategy of selling more and 
innovative  financial  products  designed  to  allow  their  customers  exposure  to  the  potential 
gains of liberalised financial markets while allowing them to assess and manage the risks for 
themselves. 

Pre-Crisis EU Regulatory Framework 

1.2. 
A fundamental assumption of EU policymakers was that the disclosure of more and relevant 
information to investors and customers would lead to a more efficient and socially optimal 
market.  Indeed,  the  EU  Council  Decision  at  Lisbon  in  June  1999  to  adopt  the  Financial 
Services Action Plan (FSAP) consisted of over forty pieces of legislation to make European 
financial markets more competitive and innovative in order to compete globally, particularly 
with  the  US  capital  markets.  The  FSAP  was  premised  on  the  notion  that  the  main  role  of 

3   See Shiller, 2000, pp. 14-17.    
4   OECD, 2011, p. 3. 
5   European Commission, Impact Assessment, 2011. 
6   Chater et al., ch. V. 
7   Chater et al., ch. I. 

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regulation in financial markets was to protect investors and consumers by disclosing more 
information  and  that  regulatory  intervention  can  only  be  justified  when  it  is  cost-effective 
and a least restrictive option to protect consumers.  

The  FSAP  legislative  agenda  included  the  Prospectus  Directive  2003  and  Prospectus 
Regulation 2004. More significantly, for this paper, was the adoption in 2004 of the Markets 
in Financial Instruments Directive I (MiFID I 2004/39/EC). Member States were required to 
transpose  and  implement  MiFID I  by  2007.  MiFID I  contained  the  overarching  principle  of 
best  execution  and  applied  to  investment  services  and  trading  venues,  including  official 
exchanges and multilateral trading facilities (MTFs). MiFID was regarded as a milestone in 
the EU’s regulation of financial markets. MiFID I set out specific provisions for harmonising 
the  regulation of investment services across the  EU and guaranteeing a minimum level of 
investor and financial consumer protection. MiFID I also contained the important objective of 
protecting the customers of banks and other financial firms in the purchase of certain financial 
products. For example, Article 19(2) MiFID I required that information addressed to clients, 
including marketing communications, should be fair, clear and not misleading8.    

Regarding the distribution of financial products, banks and other financial intermediaries were 
required to disclose the risks to clients, but there was no obligation for firms to advise clients. 
Investors were expected to assume the risks based on information and guidance provided. 
Furthermore, it was relatively straightforward for a bank or other firm to reclassify customers 
as professional clients who were not subject to heightened disclosure of risks or to any type 
of duty of care from the selling institution. Although MiFID I addressed conduct of business 
concerns  in  the  sale  of  financial  products  (including  marketing,  disclosure,  and  suitability 
requirements), there were inadequate controls regarding conflict of interests, product 
design,  and  order  execution.  Moreover,  the  widespread  and  pervasive  nature  of  mis-
selling of financial products in most EU states following MiFID I’s implementation deadline of 
January  2007  suggests  that  most  Member  States  and  some  firms  failed  to  implement  it 
adequately  into  domestic  law  and  regulation9.  For  instance,  a  2011  Study  on  the 
implementation  of  MiFID  I  found  that  firms  gathered  insufficient  information  on  clients’ 
backgrounds and abilities to invest, that firms focused more on the amount of the potential 
investment rather than on due diligence, and that investment advice provided was largely 
based on superficial information10. 

Also,  the  Directive  regulating  collective  investment  schemes  known  as  Undertakings  for 
Collective Investment in Transferrable Securities (UCITS III) 11 contained principles and rules 
for  the  regulation  of  asset  management  firms  and  other  firms  providing  collective 
investments  in  transferrable  securities.  UCITS  III  consisted  of  two  Directives:  Directive 
2001/108/EC that increased the scope of UCITS to a much broader number of instruments, 
and  Directive  2001/107/EC  that  provided  minimum  standards,  which  a  UCITS  asset 
management  company  should  comply  with  in  terms  of  capital  and  risk  control,  rules  of 
conduct and conditions relating to technical and human resources. 

Following the adoption of most of the FSAP legislative agenda, the Commission issued a White 
Paper  in  2005  (Financial  Services  Policy  Agenda  2005-2010)  that  stressed  the  need  for  a 
period of ‘dynamic consolidation’ and a legislative pause and stock-taking. During this period, 

8   Article 27 (2-8) of the MiFID I Implementation Directive (Commission Directive 2006/73/EC of 10 August 2006), 
defines the requirements for marketing communications with respect to the obligation under article 19 (2) of 
MiFID I.    

9   See  discussion  below  of  massive  mis-selling  of  financial  products  by  UK  banks  between  2008  and  2013,  and 
Kupšys,  2017,  discussing  Lithuanian  courts  upholding  bank  sales  practices  that  arguably  violated  MiFID I 
requirements that marketing communications are ‘fair, clear and not misleading.’ See article 19(2) MiFID I. 

10   See Moloney, 2015, p.747, fn 59. 
11   UCITS III consists of two directives: EU Directive 2001/108/EC of 21 January 2002, EU Directive 2001/107/EC 

of 21 January 2002. 

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the gaps and weaknesses of the FSAP sectoral approach to regulation that relied primarily 
on a disclosure paradigm for investor and  retail customer  regulation were becoming more 
apparent as episodes of mis-selling were growing more common across the EU. 

The impact of the global financial crisis of 2008 further exposed the tenuous fault lines in the 
EU FSAP regulatory approach. Serious financial market risks for retail financial clients 
were caused in part by financial institutions engaging in regulatory arbitrage due 
to  the  sectoral  approach  to  regulation.  Institutions  could  repackage  products  so  that 
they could be subject to less strict regulatory standards. Different rules applied to functionally 
similar products. For example, UCITS III – but not MiFID - required financial intermediaries 
(investment management firms) to provide a market summary disclosure for retail investors. 
For MiFID and UCITS and other legislation such as the Insurance Mediation Directive I (IMD 
I), there were very limited powers for product intervention, and ambiguities and gaps in EU 
legislation allowed Member State regulators to engage in light-touch regulation along with 
passive  supervision  that  allowed  financial  firms  to  avoid  investor  safeguards.  Despite  the 
reforms  brought  about  by  MiFID I  and  IMD  I,  the  crisis  demonstrated  weaknesses  in  EU 
regulation  of  financial  product  distribution  and  the  disclosure  of  risks 12.  The  crisis  and  its 
aftermath resulted in massive losses for retail customers and investors that were exacerbated 
by systematic mis-selling practices that understated the  risks  for  retail investors but were 
very profitable for the institutions, which sold them13.  

Persistent  mis-selling  was  also  demonstrated  during  the  transition  from  MiFID I  to 
MiFID II.14Indeed, some of the more egregious mis-selling practices in the sale of structured 
and  proprietary  products  and  of  complex  interest  rate  hedging  products  were  designed  to 
rebuild financial institutions’ balance sheets by generating more profits during the post-crisis 
economic  slowdown  and  to  offset  some  of  the  costs  associated  with  compliance  with 
prudential regulatory requirements, such as the Capital Requirements Directive IV14.  

In  the  UK,  structured  products  that  were  guaranteed  by  the  US  investment  bank  Lehman 
Brothers  were  sold  based  on  significant  advice  failures  and  serious  disclosure 
deficiencies.  The  UK  Financial  Services  Authority  (FSA)  brought  numerous  enforcement 
actions15; and the German regulator Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) 
brought actions against banks and investment firms in relation to the marketing and sale of 
Lehman debt certificates16. Across other EU Member States, regulators brought many mis-
selling actions and complaints were filed with Ombudsmen services, and alternative dispute 
resolution  methods  were  used  in  some  EU  Member  States  to  address  major  mis-selling 
problems that were exacerbated because of substantial losses that materialised during the 
crisis17. 

In addition, regulatory weaknesses were associated with mis-selling. The vulnerability of the 
investment product distribution market to market failures derived from the dominance of 
complex packaged products as retail investments; the persistent conflict of interest risk 
arising  from  the  ‘financial  supermarket’  model  or  commission-based  adviser  business 

12   See cases filed in 2015 against the Luminor bank (the successor bank of the Nordic DNB Bank) for the mis-sale 
of  index-linked  bonds  in 2007-2008  (before  and  after  MiFID I  came  into  effect) by  the  DNB  Bank,  which  had 
loaned its customers the funds to purchase products that were marketed as ‘low risk’ and ‘guaranteed’, but which 
turned  out  to  be  highly  risky.  As  a  result  of  the  bank’s  customers  purchasing  these  highly  risky  bonds,  they 
incurred substantial losses wiping out most of their principal investment (over 100 million litas, about 30 million 
euros).  The claims against the Luminor bank (then DNB Bank) are pending in the Lithuanian courts, while the 
issues of whether the bank’s sales practices were in violation of MiFID I and the Market Abuse Directive have 
been referred to the Court of Justice of the European Union (CJEU). See Kupšys (2017), p. 1. 

13   Moloney, 2014, p. 786. 
14   Moloney, 2014, p. 787. 
15   See discussion in section 1.3. 
16   Herbert Smith, p. 3. 
17   European Commission, Impact Assessment, pp. 3-5. 

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Policy Department A: Economic and Scientific Policy 

model;  proliferation  of  complex  products;  incomplete  disclosure  and  the  limited  ability  of 
investors to understand complex products18. 

MiFID I’s  process-based  quality-of-advice  rules  struggled  to  ensure  that  customers  had 
adequate information and were offered suitable products. Also, regulatory arbitrage was a 
problem,  as  MiFID I  principles  and  rules  did  not  apply to  insurance-based investment 
products  or  deposit-based  investment  products.  Financial  firm  governance  was  too 
weak to address the incentives of brokers and customer advisers who were incentivised to 
promote ‘tied’ products that paid disproportionately high commissions or ‘retrocessions’ that 
were usually not disclosed to the customer and were designed to generate related revenue 
streams  to  increase  profits  for  financial  institutions  following  their  huge  losses  during  the 
crisis19. Arbitrage also arose from segmentation and classification of investors and products20. 
The financial crisis revealed the great risks for customers – regardless of whether they were 
wholesale  or  retail  investors  -  without  adequate  market  experience  who  were  allowed  to 
invest in complex financial products by accessing the products on the wholesale market. 

UK mis-selling  

1.3. 
The  United  Kingdom  provides  an  exceptional  case  study  of  how  an  EU  Member  State  can 
implement the requirements of EU financial legislation, such as MiFID I, into its domestic law 
and regulatory framework, yet still suffer from a massive and widespread mis-selling crisis 
instigated  largely  because  of  weak  governance  practices  in  financial  firms,  light  touch 
supervisory  practices  and  inadequate  enforcement  action  by  the  regulator.  Customer 
complaints  for  mis-selling  against  UK  banks  and  financial  services  firms  received  much 
attention during the pre- and post-crisis periods, especially following the British banking crisis 
of 2007–08.  

Under English common law, all banks that sell financial products and services to clients and 
customers are generally subject to a duty of care in the sale of these products and services. 
The duty of care, however, is subject to limitations imposed by the principle of freedom of 
contract, which allows the parties in the contractual agreement to dispense with the duty of 
care,  resulting  in  a  caveat  emptor  (buyer  beware)  relationship  between  the  bank  and  its 
customer. The buyer beware relationship however does not negate the bank’s duty of care 
not carelessly to misstate facts – which means that the bank’s affirmative representations or 
statements cannot be inaccurate or false without attracting potential liability. Nevertheless, 
a bank’s duty of care to advise its clients of the risks or on the suitability of a product ‘should 
not be readily inferred in a commercial relationship’21. Depending on the financial product or 
investment  sold,  the  duty  of  care  could  entail  a  duty  to  investigate  the  suitability  of  the 
products  sold  to  customers  and,  if  appropriate,  a  duty  to  warn  customers  of  the  risks  of 
investing in these products. English courts, however, have overwhelmingly ruled against bank 
customers  who  have  claimed  that  their  banks  owed  them  a  duty  of  care  to  assess  their 
suitability for the sale of certain financial products when the parties have agreed in writing 
to dispense with the duty of care. Under English law, when the parties dispense with the duty 
of care, it is almost impossible for the customer to prevail on a mis-selling claim absent some 
showing of fraud or affirmative misrepresentation.   

Similarly,  the  UK  statutory  and  financial  regulatory  regime  has  also  struggled  to  provide 
adequate  avenues  of  redress  in  cases  involving  vulnerable  retail  customers  –  including 
individuals and small businesses – who were mis-sold financial products. After having failed 
to supervise the sales  practices  of regulated financial institutions (especially banks) in the 

18   Moloney,2014, p. 788. 
19   Moloney, 2014, p. 788. 
20   Moloney,2014, p. 791. 
21   Bankers Trust International plc v PT Dharmala Sakti Sejahtera [1996] at 531, per Mance J. 

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early  2000s,  which  resulted  in  massive  mis-selling  of  financial  products  to  individual  and 
small  business  customers,  the  former  Financial Services  Authority  (FSA)  and  the  Financial 
Conduct Authority (FCA, established in 2013) both played a more active role in encouraging 
customers and financial institutions to allow the Financial Ombudsman Service (FOS) to 
settle disputes between institutions and retail clients and small business customers22. 

The Ombudsman regime has been extensively utilised to file millions of claims against banks 
for  mis-selling  financial  products,  including  payment  protection  insurance  (PPI)  and 
derivative  products  such  as  interest  rate  swaps.  Since  the  early  2000s,  borrowers  who 
purchased PPI to insure against the risk that they may be unable to maintain loan repayments 
have sought redress for mis-selling through the FOS and the courts. The courts have clarified 
the  law  on  PPI  mis-selling  in  several  decisions  assessing  the  lawfulness  of  PPI  mis-selling 
regulations23 and on the unfair relationship between lenders and borrowers. 

The case of Harrison & Harrison v Black Horse Limited24 involved the legal question of whether 
a lender’s failure to disclose the existence or amount of commission from an insurer on their 
sale  of  PPI  to  a  customer  amounts  to  unfairness  in  the  relationship  between  the  parties 
pursuant to section 140A of the Consumer Credit Act 1974 (CCA). Both the High Court and 
Court  of  Appeal  decided  the  claim  against  the  borrower  claimants  and  their  appeal  to  the 
Supreme Court was subsequently withdrawn by consent.  

The  borrowers  had  also  claimed  that  an  unfair  relationship  was  created  by  the  lender’s25 
breach  of  the  regulator’s  intermediary  conduct  of  business  rules  (ICOB  rules)  and  the  PPI 
policy was unsuitable owing to the length of the cover and its cost26. The facts of the case 
involved two loans obtained by the borrowers from the lender, both taken out with PPI. The 
second loan was then discharged by refinance in 2009 and the PPI was cancelled. The PPI 
was sold by the lender to the borrower as agent for the actual insurer, Lloyds TSB General 
Insurance Limited; therefore, it was an insurance intermediary acting on an advise basis in 
relation to the specific PPI offered. The lender earned 87% of the premium in commission 
from  the  insurer  on  the  sale  of  the  PPI,  which  was  not  disclosed  to  the  borrowers.  This 
decision has raised the bar of proof even higher for borrowers seeking compensation in 
the courts for alleged PPI mis-selling – in particular, it cannot be argued that a lender’s failure 
to disclose their commission created an unfair relationship under section 140A of the CCA.  

Alternatively,  borrowers  can  seek  redress  through  the  FOS  which  applies  a  fairness  test 
based on the UK regulator’s treating customers fairly principle to decide cases. The use of 
the  Ombudsman  has  tended  to  result  in  more  favourable  outcomes  for  borrowers  than 
pursuing  actions  in  court27.  As  a  result,  the  vast  bulk  of  mis-selling  claims  against  British 
banks  has  been  brought  before  the  Ombudsman  based  on  the  regulatory  law  principle  of 
treating customers fairly, rather than asserting a breach of contract or tort law claim in court. 
The  British  Bankers  Association  challenged  in  court  the  regulator’s  use  of  the  Financial 
Ombudsman Service, rather than the courts, for binding resolution of mis-selling complaints 
as  beyond  the  regulator’s  powers  under  law.  However,  the  English  High  Court  issued  a 

22   The Financial Services Markets Act 2000 established the Financial Ombudsman Service (FOS) that provides a 
scheme to allow customer complaints to be adjudicated against financial services firms in cases involving general 
insurance, banking and credit, and investment services. See Financial Services and Markets Act 2000. Consumer 
credit later came under its remit on 6 April 2007 based on the Consumer Credit Act 2006. Consumer Credit Act 
2006 c.14. 

23   R (on application of the British Bankers Association) v Financial Services Authority and Financial Ombudsman 

Service [2011]. 

24   Harrison & Harrison v Black Horse Limited [2011]. 
25   The lender was part of the Lloyds TSB Group. 
26   The  applicability of  the ICOB rules  to  the bank’s  duty  of care  in  the  sale of  PPI  and  other regulated  financial 
products to commercial and individual customers has been reaffirmed in Saville v Central Capital Ltd [2014]. 
27   Financial Ombudsman Service (UK) has stated: ‘What we consider to be fair and reasonable redress will depend 

on the individual circumstances of the complaint’. 

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Policy Department A: Economic and Scientific Policy 

judgment in 2011 rejecting the BBA legal challenge and upholding the regulator’s powers to 
use the Ombudsman service to provide legally binding resolution of mis-selling complaints28. 
The Ombudsman Service is much easier and less expensive for claimants to bring mis-selling 
claims  compared  to  the  courts,  and  will  likely  become  the  main  avenue  for  redress  by 
claimants.   

In summary, following the mis-selling scandals, the UK regulatory authorities have utilised 
the Ombudsman Service to resolve mis-selling complaints against banks with legally binding 
effect. This has had the effect of expanding the scope of the bank’s potential liability 
for mis-selling 29. As discussed above, the most prominent application of UK regulatory rules 
to banks mis-selling of financial products came in respect of the sale of payment protection 
insurance (PPI). The UK regulator adopted regulatory guidelines and a policy statement on 
PPI  complaints  handling  that  reflects  a  stricter  approach  to  ensuring  that  bank  customers 
have  an  adequate  remedy  to  resolve  their  mis-selling  claims  before  the  Financial 
Ombudsman, which should serve as a precedent for customers in bringing future claims. 

1.4. 

Pre-crisis EU regulatory reforms shortcomings 

MiFID I, UCITS and other pre-crisis EU legislation did not prevent another wave of large-scale 
mis-selling scandals that occurred just before and after the financial crisis30. For instance, 
the UK attempted to address this by proposing in 2007 the Retail Distribution Review (RDR), 
which  came  into  force  in  2013,  that  sought  to  address  the  regulatory  weaknesses  for  the 
marketing  and  sale  of  financial  products.  The  RDR  contained  a  ban  on  commission  in 
distribution  of  packaged  investment  products,  imposed  strict  labelling  requirements  on 
whether advice is independent or restricted, and stringent qualification rules for investment 
advisers31.  The  UK  reforms,  however,  did  not  address  other  types  of  commission-based 
compensation  and  incentive  problems  caused  by  conflicts  of  interest.  Similarly,  across 
Europe,  weaknesses in the regulation of incentives for ‘tied’ agents in the sale of financial 
products resulted in pervasive mis-selling by European financial institutions and investment 
firms of structured and other complex and risky products (i.e. interest rate hedging products) 
pre-crisis  to  individuals  and  small  businesses  which  continued  post-crisis  in  many  EU 
countries, such as Spain, Slovenia and the UK 32.  

MiFID I concerns arose particularly regarding advice for the sale of unsuitable products 
and the impact of complex products on investors who did not fully appreciate the 
risk 33.  Moloney  observed  that  although  MiFID I  addressed  the  distribution  of  financial 
instruments, not much success was achieved in preventing mis-selling during and after the 
crisis34. Although MiFID I applied to the sale of many products sold by banks and securities 
firms, it did not apply to many other financial instruments and products governed by other 
directives. For instance, it did not apply to unit-linked investments, distribution of which is 
subject to the Insurance Mediation Directive (less detailed than MiFID I although it contained 
some protections which MiFID I did not)35. 

28   R (on application of the British Bankers Association) v Financial Services Authority and Financial Ombudsman 

Service (per Ouseley J) [1999]. 

29   UK Financial Supervisory Authority Policy Statement, p. 1. 
30   Moloney 2015, p. 759. 
31   Moloney, 2015, p. 759. 
32   The mis-selling of Bankia preferred shares Spain in 2009, subordinated bonds in Slovenia in 2013-2014 and the 
current  discussion  on  the  mis-selling  relating  to  the British  Steel  Pension Scheme.  See Better  Finance,  2017, 
Financial Times, 15 February 2018. 

33   European Commission, Review of MiFID.  
34   Moloney, 2014, p. 805. 
35   Moloney, 2010b, p. 336. 

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Moreover,  Colaert  asserts  that,  after  entry  into  force  of  MiFID I,  mutual  funds  were  often 
repackaged as life insurance products or as structured deposits to avoid the MiFID regime 
(regulatory arbitrage)36. Thus, Member States requested a wider scope of MiFID conduct of 
business  rules  to  expand  MiFID I  coverage  to  include  certain  insurance  products  and/or 
structured  deposits,  while  some  Member  States,  such  as  the  UK  and  France,  largely 
duplicated MiFID-like rules into their domestic insurance law37.  

The Commission’s Staff Working Paper of the Impact Assessment accompanying the MiFID II 
and  MiFIR  proposals  identified  major  concerns  and  uncertainties  about  the  way  certain 
services are delivered to investors, such as the scope of execution-only services, the quality 
of investment advice, or the framework for inducements. For the latter, the MiFID rules for 
disclosure on incentives from third parties have not always proven to be very clear or well-
articulated for investors. The mis-selling cases have created issues regarding the provision 
of services to non-retail clients and the classification of clients as either professional or retail. 
However, the lack of data on execution quality could impair the ability of investment firms to 
select the best possible venue for executing a trade for a client. 

Crisis results in further changes to MiFID  

1.5. 
The crisis demonstrated that regulatory disclosures were insufficient to solve information 
asymmetries and conflicts of interest, nor to address the risks associated with the volume 
and complexity of information. This showed the need to move away from primary reliance 
on the information disclosure paradigm that enshrines the notion of the empowered investor 
and confident consumer to a new philosophy of ‘consumer protection’ and the need to ‘treat 
customers  fairly’.  This  new  focus  on  suitability  and  treating  customers  fairly  implies  that 
regulators should occasionally intervene in the market and adjust or ban certain products. 
Indeed, the need for product intervention in response to complex products, acknowledges 
the limits of disclosure and financial literacy in addressing market failures.  

36   Colaert,  2017b,  p.  591;  European  Commission,  2008,  p.  11,  stating  that  in  France,  sales  of  unit-linked  life 

insurance increased following the implementation of MiFID. 

37   Colaert, 2017a, p.18. 

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  POST-CRISIS REGULATORY APPROACH - MIFID II/ MIFIR 

KEY FINDINGS 

The Markets in Financial Instruments Directive/Regulation (MiFID II/MIFIR) was the most 
significant  EU  legislation  to  reform  the  marketing,  sale  and  distribution  of  financial 
products. MiFID II focuses on three main areas: distribution, disclosure, and product 
intervention,  and  has  wide  application  to  all  financial  institutions  and  infrastructure 
including banks, investment firms, fund managers, exchanges and other trading venues, 
high  frequency  traders,  brokers  and  pension  funds  and  retail  investors.  Regarding 
financial products, its requirements apply to designated MiFID financial instruments and 
products  that  relate  to  equities,  fixed  income,  commodities  and  foreign  exchange. 
Although  MiFID II  covers  a  wide  range  of  financial  instruments,  it  does  not 
comprehensively  address  distribution  of  insurance-based  products  (governed  by  the 
Insurance  Distribution  Directive)  and  depository-based  investments.  Also,  the  MiFID II 
inducement regime does not include a ban on commissions across all sales channels, but 
only  applies  the  ban  to  independent  advisers.  It  raises  the  question  of  whether 
commission or tied products should be prohibited or restricted across all sales channels. 
Because  MiFID II  does  not  apply  to  other  financial  instruments  regulated  by  insurance 
supervisors or covered by other EU legislation, it raises the concern of segmentation 
risks and regulatory arbitrage.  

A Change in Focus  

2.1. 
The post-crisis regulation reforms for the marketing and sale of financial products and related 
investment  services  focus  on  three  main  areas:  distribution,  disclosure,  and  product 
intervention. Under these legislative and regulatory reforms, a different precautionary ex 
ante approach is taken to retail markets and product distribution38. This approach adopts a 
different rationale for the regulation of the sale and distribution of financial products, which 
moves away from the disclosure paradigm to a behavioural finance paradigm. As mentioned 
in  Chapter  1  above,  pre-crisis  the  regulation  of  the  sale  of  retail  financial  products  and 
investment  services  was  based  on  a  disclosure  paradigm  that  assumed  that  investors  can 
rationally  assess  information  that  is  disclosed  to  them  and  then  based  on  this  and  other 
information widely available in the market decide which financial products to invest in order 
to  maximise  their  individual  utilities  and  achieve  the  greatest  risk-adjusted  returns.  In 
contrast, the behavioural paradigm suggests that bank clients and investors are not able 
to process all the relevant information and to calculate the risks, and that regulation should 
be designed to play a more interventionist role to limit, for example, the potential downside 
losses of risks for customers and to take account of behavioural biases that arise from social 
and biological factors 39. 

2.2.  MiFID II/MiFIR 
MiFID II has the stated objective of making European financial markets safer, fairer and more 
transparent  and  to  restore  investor  confidence  after  the  financial  crisis.  Following  the 
regulatory  reforms  which  took  place  worldwide  after  the  2007–08  financial  crisis,  the 
European Commission attempted to address gaps and weaknesses in MiFID I by replacing it 
with  Directive  2014/65/EU  (MiFID II)  and  adopting  Regulation  No  600/2014  (MiFIR)40  to 
furthermore close the gaps created between MiFID II and EMIR (Regulation (EU) 648/2012). 

38   Moloney, 2014, p. 789. 
39   See Shiller, 2000, p. 27.  See also Coates and Herbert, 2008, p. 6169. 
40   Directive  2014/65/EU  (Markets  in  Financial  Instruments  Directive/  MiFID II),  Regulation  (EU)  No  600/2014 

(Markets in Financial Instruments Regulation/ MiFIR). 

16 

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The European Commission has issued a number of delegated acts further specifying the rules 
under MiFID II41 and MiFIR42. MiFID II was required to be transposed into Member State law 
by July 2017 and, together with MIFIR, became legally enforceable on 3 January 201843. The 
Commission launched 19 infringement actions in October 2017 against Member States who 
had failed to transpose the legislation by the deadline44.  

MiFID  II  applies  to  all  financial  institutions  and  infrastructure  including  banks,  investment 
firms, fund managers, exchanges and other trading venues, high frequency traders, brokers 
and  pension  funds  and  retail  investors.  It  widens  the  scope  of  application  of  provisions 
including conduct of business rules to cover a broad range of markets including equities, fixed 
income,  commodities  and  foreign  exchange,  and  products,  including  futures,  exchange 
traded products, retail derivatives such as contracts for differences and structured deposits 
(Article  1(4)  MiFID II) 45.  MiFID II  aims  to  require  most  trading  to  take  place  on  regulated 
markets,  including  exchanges,  Multilateral  Trading  Facilities  (MTFs),  Organised  Trading 
Facilities (OTFs) and Systematic Internalisers. MiFID II empowers regulators to require more 
transparency for off-exchange markets and volume caps for equity ‘dark pools’. Banks and 
other financial intermediaries are required to unbundle client payments for analyst research 
and trading commissions, and provide stricter standards for investment products.  

The unbundling of client payments for analyst research and trading commissions is likely 
to affect how financial products are sold and how investment advice is rendered. Indeed, it 
is an important part of the MiFID II regime that regulates how asset managers pay for the 
research they use to make investment decisions. It was a major concern to what regulators 
saw as a conflict of interest at the heart of trading that hurts asset managers’ clients including 
pension funds, ordinary savers and retail investors because banks that were acting as brokers 
for asset managers were able to pass along the cost of research to the asset managers who 
would then pass the costs on to their clients without disclosure. Basically, pre-MiFID II, asset 
managers received research, including written reports and phone calls with analysts, for free 
from banks and other financial firms, although the cost of this service was built into trading 
fees, which are usually paid by fund managers’ clients. For the first time, fund managers will 
have to budget separately for research and trading costs, otherwise known as unbundling.  

The unbundling and organisational requirements are expected to have an impact beyond the 
EU. The EU demands for the personal details of traders are already creating tensions with 
the privacy rules  of  other jurisdictions outside the EU,  such as  Hong Kong and Singapore. 
The  new  regime  on  research  payments  also  poses  a  significant  challenge  for  US  brokers. 
Under US regulations, brokers cannot receive direct payments for research unless they are 
formally registered as investment advisers. This means, in theory, that they will not be able 
to provide research to European clients — who will be obliged to make direct payments for 
this service — from 2018, unless they are registered with the US Investment Advisers Act 
1940.  The  Securities  and  Exchange  Commission  (SEC),  the  US  regulator,  has  the  power, 
however, to waive the rules and allow brokers to receive direct payments for research from 

41   Commission Delegated Regulation of 25.04.2016 supplementing Directive 2014/65/EU; Commission Delegated 

Directive of 07.04.2016 supplementing Directive 2014/65/EU. 

42   Commission Delegated Regulation of 18.05.2016 supplementing Regulation (EU) No 600/2014; ‘Overview and 
state  of  play  of RTS  and ITS relating  to  MiFID/MiFIR’.  The Commission has  adopted  more  than  30  delegated 
Regulations  for  MiFID II  and  MiFIR,  with  28  of  them  are  commonly  referred  to  as  ‘RTS’.  The  full  list  of  the 
delegated regulations can be found for MiFIR at: https://ec.europa.eu/info/law/markets-financial-instruments-
mifir-regulation-eu-no-600-2014  and 
for  MiFID II  at:  https://ec.europa.eu/info/law/markets-financial-
instruments-mifid-ii-directive-2014-65-eu_en. 

43   Regulation (EU) 2016/1033; Regulation (EU) No 596/2014; Directive (EU) 2016/1034.   
44   See  European  Commission  Press  Release  (2017)  http://europa.eu/rapid/press-release_MEMO-18-349_en.htm 
As of 20 February 2018, 10 Member States still have not fully implemented MiFID II and Commission Delegated 
Directive (EU) 2017/593. 

45   Annex I, Section C MiFID II lists all financial instruments covered by MiFID II. 

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investors who are subject to MiFID II. The SEC is expected to make  a decision in 2018 or 
2019; but in the meantime US banks and other institutions which employ these brokers will 
come under pressure to comply with the MiFID II rules and if they do so they will agree to 
register with the SEC as investment advisers in order to be able to continue servicing clients 
with EU operations.  

MiFID II  also  addresses  the  selling  processes  of  financial  institutions  by  adopting  rules 
governing  their  organisational  requirements  and  conduct  of  business  provisions.  As  to  the 
organisational requirements of banks, reference is made to the new provisions on product 
governance arrangements relating to banks which develop financial products and to those 
which sell them46. The purpose of such provisions is to enhance the banks’ understanding of 
the products they develop or sell and to ensure that they are suitable to the clients to whom 
they are being sold47. To this end, investment firms are required to maintain, operate 
and  review  the  process  for  approval  of  each  financial  instrument  and  significant 
adaptations of existing financial instruments before it is marketed or distributed to 
clients48. Moreover, specific record-keeping provisions have been laid down in the context 
of  the  organisational  requirements.  In  particular,  records  shall  include  the  recording  of 
telephone  conversations  or  electronic  communications  relating  to,  at  least,  transactions 
concluded when dealing on own account and the provision of client order services that relate 
to the reception, transmission and execution of client orders. Banks or investment firms must 
also notify new and existing clients that telephone communications or conversations between 
the firm and its clients that result, or may result, in transactions will be recorded49.  

Sales targets and remuneration rules are also applicable to banks and other covered financial 
intermediaries.  These  rules  are  based  on  the  European  Securities  and  Markets  Authority’s 
(ESMA)  Guidelines  on  Remuneration  Policies  and  Practices  and  aim  at  ensuring  that  staff 
incentives do not result in conflict of interests or impinge upon the firm’s obligation to act in 
the  best  interest  of  the  client50.  Finally,  as  to  conduct  of  business,  Articles  25  and  27  of 
MiFID II narrow the list of execution-only products and widen the list of information banks or 
investment firms have to provide with regard to best execution51.  

The  MiFID II/MiFIR  closed  the  exception  for  non-advice  execution-only  financial  products, 
including for structured UCITS product that are marketed to retail customers and makes it 
more difficult for a retail client to be opted-up to professional client status. MiFID II creates 
high  level  requirements  on  the  distribution  of  insurance-based  investment  products.  It 
prohibits  firms  from  offering  lending  (margin)  services  in  conjunction  with  execution-only 
services.  It  creates  a  new  category  of  ‘independent  investment  advice’,  in  which  advice 
labelled  as  independent  must  advise  clients  on  a  cross-market  selection  of  financial 
instruments. There is also a prohibition on commission payments for independent advice and 
a prohibition on commission payments for discretionary asset management. 

MiFID II  now  contains  a  stronger  principle  of  fair  treatment  that  includes  a  fiduciary-
style obligation on the investment firm to act fairly in the client’s best interests (Art 24(1) 
MiFID II), and a duty to act honestly, fairly, and professionally in accordance with the best 
interests of firm’s clients. This is known more generally as a duty of loyalty that is designed 
to address the weaknesses with the previous information disclosure regime that did not take 
account  of  the  disadvantages  confronting  clients  who  often  suffer  from  asymmetric 

46   See Busch, 2017, p.124. 
47   MiFID II, Art 16. 
48   MiFID II, Art 16(3). 
49   MiFID II, Art 16(6) and (7). It should also be mentioned that to ensure that record keeping occurs properly, the 

investment firms must even synchronise their clocks with clocks at the exchanges.   

50   MiFID II, Art 24(10). 
51   MiFID II, Arts 25 and 27. 

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information  problems  and  behaviour  biases52.  Also,  regarding  marketing,  Article  24(3) 
requires  that  all  information  addressed  by  a  firm  to  clients  to  be  ‘fair,  clear  and  not 
misleading’53.  

MiFID II  now  regulates  the  quality  of  advice  rendered  to  clients  by  requiring  financial 
advisers to undergo training and have minimum education in finance and related fields before 
they can be authorised as agents who can advise clients. This involves demonstrating that 
the products they sell their clients are suitable: the suitability assessment must be based on 
a ‘know your customer’ (KYC) assessment. Advisers are required to state whether the advice 
is provided on an independent basis or not. 

Regarding a firm’s execution-only regime, there are more prescriptive rules regarding when 
clients can be treated only for trade execution purposes, and there are limitations regarding 
which products can be sold on an execution basis only. However, MiFID does not apply these 
restrictions to a number of other structured investment products that can be sold by asset 
management firms under the UCITS directive on an execution-only basis. 

Regarding  product  intervention,  MiFID II/MiFIR  confers  on  ESMA  and  Member  State 
regulators  in  consultation  with  ESMA  the  power  to  prohibit  or  restrict  the  marketing, 
distribution, or sale of a particular financial instrument or type of activity. MiFID II also makes 
a stricter distinction between eligible counterparties54, professional and retail investors, and 
the ability of retail clients to opt-up to the professional client classification, which provides 
fewer safeguards for the client.  

Compared to MiFID I, MiFID II aims to enhance the level of protection of different categories 
of clients. However, there will be room for further analysis once the implementation process 
is completed in accordance with the Commission’s ongoing level 2 rule-making process and 
the final level 3 compliance and  enforcement  stage. Before the  Brexit referendum, the UK 
competent authorities were considering the necessary changes for transposing MiFID II into 
domestic  legislation55.  In  particular,  they  were  assessing  the  impact  that  the  new  EU 
legislation may have on the ability of UK credit institutions and investment firms to contract 
out of their duty of care to retail and wholesale customers and to limit their liability to both 
consumer and commercial customers56. 

2.3.  MiFID II Shortcomings 
The reform of the provision of independent advice was an attempt to resolve the conflict of 
interest problem, but the reforms are apparently having limited effect, as they target only 
independent investment advice and therefore will affect only a very small segment of EU 
product distribution market. MiFID II also seems to lack specific requirements for strict 
supervision of organisational governance requirements to prevent conflict of interests 
in the design and sale of financial instruments and products.  

Moreover, MiFID II has been criticised for not going far enough in regulating the marketing 
or  promotion  of  financial  products.  As  with  MiFID I,  MiFID II  contains  a  requirement  that 
marketing materials are required to be ‘fair, clear and not misleading’57. However, MiFID II 
goes  further  with  additional  requirements  regarding  the  distribution  of  research  and 

52   Moloney, 2014, p. 800. 
53   See Enriques and Gargantini, 2017. 
54  ‘[E]ligible  counterparties’  have  the  least  protection  under  MiFID II  and  impose  the  fewest  duties  on  the 

investment firms. 

55   The Financial Services and Markets Act 2000 (Qualifying EU Provisions) (Amendment) Order 2016. This Order 
applies some amendments to the Financial Services and Markets Act 2000 (Qualifying EU Provisions) Order 2013. 
The purpose of these amendments is twofold: (1) to make MiFIR a qualifying EU provision for various parts of 
FSMA; and (2) to ensure that the FCA and PRA have the appropriate powers to perform their roles under MiFIR. 

56   HM Treasury, 2010, pp. 15-16. 
57   Art. 24(3) MiFID II. 

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marketing  materials in Articles  36  and  37  of  Commission  Delegated  Regulation  2017/565. 
Furthermore, MiFID II cross-references the Market Abuse Regulation (MAR) by requiring MAR 
principles  to  be  adhered  to  regarding  what  information  goes  into  marketing  and  research 
documents.   

financial 

instruments, 

Although  MiFID II  covers  a  wide  range  of 
it  does  not 
comprehensively address distribution of insurance-based products (governed by the 
Insurance Distribution Directive (IDD)).58 However, MiFID II has made targeted reforms to 
the distribution of insurance-based products by imposing additional conflict of interest and 
disclosure-related  obligations  on  the  direct  sales  and  distribution  and  advice  of  insurance-
based investment products. MiFID II provides high-level requirements for the distribution of 
insurance-based  products  by  insurance  companies;  but  the  IDD  remains  a  lighter  touch 
regime  that  imposes  less  strict  standards  regarding  how  advice  is  rendered  by  insurance 
firms  and  also  allows  for  commissions  and  inducements  for  the  sale  of  insurance-based 
products 59. 

MiFID II  also  contains  incomplete  disclosure  requirements  on  the  distribution  of  financial 
instruments  and  products  covered  by  the  Directive.  For  instance,  it  does  not  address 
standardisation or format, or how retail-oriented summary disclosures should be designed. 
Moreover, the regulation of financial products is a new and untested tool for the EU and may 
have  unexpected  effects.  Particularly  the  power  to  impose  product  bans  may  lead  to  an 
intrusive and heavy-handed regulatory approach. It places a great deal of authority with the 
regulator to find the optimum levels of risk and choice in the retail market60. Nevertheless, 
the new regulatory framework has merits in seeking to impose controls on the distribution of 
extremely risky financial products to retail customers whose principal value can be lost. 

Other weaknesses with MiFID II include the concern that although it aims to protect clients 
it  does  not  accomplish  this  because  of  the  lack  of  standardised  information  disclosed  to 
customers  and  the  lack  of  any  consistent  format  to  present  information  on  costs,  charges 
and risks between different financial services providers61. As a result, industry bodies have 
attempted to fill the gap by encouraging member firms to prepare a European MiFID Template 
(EMT)  that  attempts  to  provide  standardised  information  for  customers,  but  this  is  not 
compulsory. However, this does not seem to work, as a recent study by the UK investment 
adviser SCM Direct found that of 10 large fund management groups with total assets of GBP 
387 billion, only 40% disclosed MiFID II costs and charges on their website using EMT62.  

Moreover, regarding advice, MiFID II does not differentiate between client groups with 
different  levels  of  financial  literacy63.  Effective  advice  requires  different  advice  for 
different client groups with different investment objectives. Also, it is argued that MiFID II 
uses too many rules and instruments to achieve identical goals, thereby generating excessive 
compliance  costs.  This  would  potentially  drive  banks  out  of  some  segments  of  the  retail 
business. Also, the MiFID II inducement regime does not include a ban on commissions across 
all sales channels, but only applies the ban to independent advisers. It raises the question of 
whether  commission  or  tied  products  should  be  prohibited  or  restricted  across  all  sales 
channels.  

58   See Colaert, 2017 b. 
59   Moloney, 2014, p. 778. 
60   Moloney, 2014, p. 834. 
61   Franke, Mosk, Schnebel, 2016, p. 1. PRIIPS, in contrast, requires disclosure of standardised document for costs 

and charges.   
62   SCM Direct, 2018. 
63   However,  MiFID II  does  provide  different  levels  of  protection  between  retail  investors  (highest  protection), 

professional clients (mid-level protection, and eligible counterparties (low to no protection).   

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MiFID II requires extensive disclosure of the risks associated with financial products and the 
compensation  arrangements  around  the  distribution  of  such  products.  These  disclosure 
requirements have been criticised because they may lead to long complex disclosures for 
customers,  which  is  especially  challenging  for  retail  clients64.  Such  complex  and 
extensive  disclosures  may  be  benefitting  the  firm  more  than  the  customer.  Also,  it  is  not 
clear whether MiFID II restrictions on investment products sold execution-only may enhance 
investor protection 65. 

Finally, MiFID II’s restriction on conflicts of interest, especially concerning the disclosure and 
inducement rules, only applies to the sale of MiFID-scope instruments. This has created the 
incentive to promote products not subject to regulatory controls under MiFID, thereby leading 
to  the  possibility  of  firms  arbitraging  the  marketing  and  sale  of  unit-linked  investments, 
insurance-based and deposit-based investments66. Investors confronted with Packaged Retail 
and  Insurance-based  Investment  Products  (PRIIPs)  (Regulation  (EU)  No  1286/2014)  may 
assume that similar regulatory protections apply to other products as well. Member States 
have  the  discretion  to  require  stricter  standards  and  requirements  than  what  the  MiFID II 
regime requires. For example, the UK Retail Distribution Review resulted in the extension of 
the  MiFID II  regime  to  other  structured  and  insurance-based  products.  The  UK  super-
equivalence approach could also be utilised by other Member States who would like to apply 
the MiFID II controls to other non-MiFID II instruments. 

64   See Conradi, 2018, p. 39, discussing report of SCM Capital showing that most UK investment service firms do 
not provide standardised information on costs, charges and risks for different investment products, nor are they 
comparable between different investment firms. 

65   UK House of Lords, 2015, p. 50. 
66   Moloney, 2010 b, p. 337. 

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  OTHER EU LEGISLATION: UCITS IV/V, AIFMD, IDD 

KEY FINDINGS 

As  with  MiFID II,  other  EU  legislative  reforms  regulating  the  marketing  and  sale  of 
financial products are now focusing on the quality of disclosure and simplification of 
information disclosed. UCITS IV and UCITS V provide a model for this occurring in the 
fund  management  industry  by  requiring  asset  management  firms  to  disclose  a 
standardised  ‘Key  Investor  Information  Document’  (KIID)  to  all  investors  before  a 
contract can be concluded with an investor. Nevertheless, the crisis revealed that there 
are gaps in the prudential regulation of UCITS fund management firms and the need for 
enhanced operational risk controls for depositaries as well.  

3.1.  UCITS IV (2009/65/EC) and UCITS V (2014/91/EU) 
UCITS IV  focuses  on  the  regulation  of  product  design  for  investors  who  are  sold  units  or 
shares in collective investment schemes. A key feature of product design is the ‘Key Investor 
Information Document’  (KIID)67. The KIID is designed to provide investors with important 
information in non-technical language. Related to the KIID, investors are entitled to receive 
a  prospectus  that  details  the  underlying  assets  and  explains  the  related  risks.  An  asset 
management or investment firm regulated under UCITS IV can mitigate its exposure to civil 
liability in the sale of a UCITS investment product by providing the investor with a KIID. Civil 
liability for the sale of UCITS investment products can only arise if the KIID is misleading, 
inaccurate or inconsistent with the relevant parts of the prospectus. 

Also,  UCITS IV  removed  barriers  to  improve  investor  disclosure  and  adopt  more  detailed 
standards for conduct of business in the design of funds, but did not address wider issues 
and systemic and operational risks that emerged during the crisis68. It also aims to address 
the need to increase investor protection and improve investor confidence by enhancing rules 
on responsibilities of depositaries, introducing remuneration policies, and increasing related 
regulatory  and  supervisory  powers.  It  also  seeks  to  bring  rules  on  depositaries  and 
remuneration in line with AIFMD 69. 

The European Commission engaged in a future framework for investment funds (Consultation 
paper, 201270) that raised important issues that were addressed in the revision of UCITS and 
the adoption of UCITS V. UCITS V specifies the vital functions of depositaries and sets forth 
prudential  controls  on  their  operations.  It  also  addresses  investment  firm  remuneration 
policies  and  practices,  and  sets  forth  standards  and  requirements  to  enhance  investor 
protection, such as liquidity requirements for money market funds and internal controls to 
improve risk governance. Moreover, it discusses efficient portfolio management techniques, 
long-term investment culture and the suitability of investment products. 

3.2.  UCITS VI? 
The  Commission  consultation  paper  in  2012  addressed  UCITS  product  rules,  liquidity 
management, depositary money market funds and long-term investments71. It reviewed the 
types  of  eligible  assets  for  a  UCITS  fund.  It  addresses  regulatory  concerns  such  as  the 
appropriateness  of  application  of  highly  sophisticated  investment  strategies  for  a  UCITS 

67   The UCITS KIID should not be confused with the Key Information Document (‘KID’) required under the Packaged 

Retail Investment Insurance Directive (PRIIPS) (discussed below).   

68   Norton Rose Fulbright, pp. 2-3. 
69   Norton Rose Fulbright, pp. 2-3. 
70   European Commission, Consultation on UCITS.  
71   European Commission, Consultation on UCITS. 

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product; current common practice to gain exposure to non-eligible assets through financial 
derivatives  instruments  linked  to  indices,  closed-ended  funds  or  structured  transferable 
securities. It also analyses the liquidity rules for eligible assets and exposure to non-eligible 
instruments by adopting a look-through approach or diversification rules at the underlying 
asset level72. 

Commentators have emphasized the need for a UCITS VI to have enhanced standards for 
efficient  portfolio  risk  management,  especially  regarding  how  fund  managers  manage 
their lending exposures in the short-term lending and repurchase (repo) agreement market. 
A  revised  UCITS  should  require  more  risk  management  standards  for  fund  managers  and 
require  them  to  test  the  effectiveness  of  portfolio  management  techniques,  especially  in 
respect to liquidity risks. There should be more specific criteria for the eligibility of assets in 
a UCITS fund and for the types of collateral that can be held for short-term securities lending 
transactions  and  mandatory  haircuts  for  collateral  during  periods  of  market  turbulence. 
Regulators should work with managers on diversifying their asset exposures and the type of 
collateral they hold for short-term lending and repo markets and for the re-use of collateral 
in other types of transactions. 

Regarding  the  types  of  assets  held  in  a  UCITS  fund,  practitioners  have  noted  the  need  to 
have  more  clarity  on  the  use  of  over-the-counter  derivatives  (OTC)  in  a  UCITS  fund.  The 
Commission consultation paper also considers the introduction of a European passport for 
depositary banks and on measures to foster long-term investments for retail investors73. 

Moloney74  has  raised  the  issue  of  segmentation  risk  that  arises  from  certain  investment 
products  that  are  covered  by  MiFID  product  distribution  requirements  which  are  not  also 
applicable to UCITS products or other insurance-based investment products. Specifically, the 
2009  UCITS IV  Directive  does  not  address  the  distribution  of  UCITS  units  by  UCITS  or  its 
managers,  although  it  requires  that  all  marketing  communications  must  be  fair,  clear  and 
not misleading and consistent with prospectus disclosures (UCITS IV, Article 77). As UCITS 
investments  are  not  covered  assets  under  MiFID,  they  are  not  subject  to  the  distribution 
rules,  remuneration  restrictions,  and  product  intervention  powers  of  MiFID.  As  such,  it 
becomes  clear  that  different  coverage  and  purposes  of  the  regulatory  instruments  create 
gaps and overlapping application that undermines consistency in application. For instance, 
the limited scope of MiFID II to certain financial products excludes certain UCITS products 
whose design and distribution would not be subject to the same safeguards against conflicts 
of interest.     

AIFMD (2011/61/EU) 

3.3. 
The Alternative Investment Fund Managers Directive (AIFMD) aims to create a harmonised 
European  regime  for  alternative  investment  funds  (such  as  hedge  funds,  real  estate  and 
private  equity)  and  their  managers75.  The  number,  size  and  riskiness  of  alternative 
investment funds are  many and they pose different levels of  risk to their investors and to 
society.  Regulations  governing  alternative  asset  managers  were  subject  only  to  minimum 
disclosure standards pre-crisis. The AIFMD is designed to increase transparency of risk 
exposures so that regulators can monitor leverage exposures and other risks that could 
threaten financial stability and undermine investor protection. Article 17 of AIFMD requires 
minimum levels of due diligence, transparency and risk retention for fund managers for their 
investments  in  securitisation  positions.  AIFMD  essentially  provides  for  an  extension  of  the 
disclosure and prudential requirements of the UCITS regime to include all non-UCITS fund 

72   Deloitte, 2014, p. 2. 
73   Deloitte, 2014. 
74   Moloney, 2014, p. 336. 
75   Ernst & Young, 2015, p. 2. 

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managers, including private equity, property and commodity fund managers. On the other 
hand,  there  is  concern  that  AIFMD  allows  fund  managers  to  sell  very  risky  products  to 
professional investors, which would otherwise not be permitted under MiFID II.  

A major criticism of the AIFMD framework is that it has very wide scope of coverage and 
market participants are critical that its ‘one size fits all’ regulatory approach fails to address 
adequately the different levels of risk that alternative investment funds pose. The disclosure 
requirements  and  risk  management  controls  are  fairly  extensive  and  arguably  impose 
disproportionate costs on certain segments of the asset management sector. The regulations 
are  also  criticised  as  putting  at  risk  the  competitiveness  of  the  EU  asset  management 
industry.  It also  creates a disincentive for third country funds and their managers to  seek 
access  to  EU  markets,  thereby  restricting  investor  choice  and  overall  asset  and  funding 
diversification76. 

In  2017,  the  EU  adopted  Regulation  (2017/2402/EU)  (known  as  the  ‘Securitisation 
Regulation’), that applies to securitisation transactions by requiring the originators, sponsors 
and  lenders  to  be  directly  obliged  to  meet  the  prudential  requirements  of  the  Regulation, 
rather  than  (as  is  currently  the  case  under  AIFMD,  2011/61/EU)  requiring  the  alternative 
investment fund manager, as the investor, to be responsible that the originators, sponsors 
and lenders have complied. This results in the repeal of Article 17 AIFMD. However, AIFMD 
has a new provision stating that where AIFMs are exposed to securitisation positions, which 
do not meet the requirements of the Securitisation Regulation, the AIFM shall take corrective 
action. 

General gaps of the current framework 

3.4. 
The  EU  legal  and  regulatory  framework  governing  the  marketing,  sale  and  distribution  of 
financial  products  fosters  segmentation  of  requirements  and  risk  management 
practices  across  different  financial  product  classes.  This  segmentation  of  regulatory 
requirements creates unnecessary inefficiency in the markets. For instance, certain products 
that are covered by MiFID II but not by the Insurance Mediation Directive will face different 
conduct  of  business  risks  and  will  have  different  requirements  regarding  remuneration, 
including the payment of bonuses, and risk management. This will influence business models 
and the types of products offered. It may also lead to an uneven regulatory playing field and 
contribute  to  arbitrage  and  lower  standards  in  the  sale  and  distribution  of  products,  thus 
potentially  leading  to  biased  advice,  poor  product-selection,  and  inappropriate  advice  to 
switch products.  

The  current  EU  legislative  framework  governing  the  marketing,  sale  and  distribution  of 
financial products and related investment services attempts to address key mis-selling and 
distribution risks. However, the different legislative and regulatory requirements for financial 
products and investments in different financial sectors have created a silo-based regulatory 
system that encourages regulatory arbitrage and results overall in poor investor outcomes. 
Financial  institutions  and  other  product  providers  have  incentives  to  design  products, 
which respond to arbitrage possibilities rather than to investor needs77. Moreover, 
the disclosure requirements across MiFID II, UCITS V and AIFMD are fragmented. For retail 
investors, it is extremely complex and difficult to recognise the different levels of protection 
attached  to  functionally  similar  products,  but  which  are  governed  by  different  legal  and 
regulatory requirements. 

76   UK House of Lords, 2015, pp. 1-2. 
77   Moloney, 2010 a, p. 185. 

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  THE AGENCY DESIGN OF FINANCIAL REGULATION 

KEY FINDINGS 

This  section  considers  what  type  of  institutional  structure  is  appropriate  for  the 
supervision of consumer financial protection. After reviewing the main supervisory models 
–  functional,  institutional,  integrated,  and  twin  peaks  –  it  recommends  that  the 
institutional design of financial regulation within EU Member States should be based on 
the principle that consumer financial protection cannot be discharged efficiently 
and effectively if it is conducted within the same agency as banking supervision. 
The rationale for this is similar to that where the competition authority is separated from 
the financial stability agency because, on occasion, their objectives may conflict. In the 
United  States,  the  Dodd-Frank  Act  2010  created  an  independent  Consumer  Financial 
Protection  Bureau  (CFPB)  with  enforcement  powers  whose  governance  and  decision-
making  authority  is  separate  from  the  agencies  responsible  for  banking  supervision. 
However,  in  most  EU  Member  States,  the  prudential  supervisor  is  typically  also 
responsible for consumer financial protection. The section concludes that the CFPB model 
should be followed by Member States, but this model would probably be legally unsound 
at the EU level because of the constitutional doctrine of conferred powers and Article 5 of 
the Lisbon Treaty containing the principle of subsidiarity. 

The  institutional  design  of  financial  regulation  has  historically  differed  between  states  and 
jurisdictions.  Generally,  four  main  supervisory  models  of  financial  regulation  provide  the 
canvas  on  which  states  develop  their  institutional  structures  of  financial  regulation  and 
supervision. These models are known as the ’functional, institutional, integrated, and 
twin  peaks’  approaches78.  According  to  the  ‘functional’  approach,  supervisors  are 
responsible  for  the  type  of  financial  business  or  function  of  a  firm  or  institution.  Different 
supervisors would have responsibility for different lines of financial business.  

In  contrast,  the  ‘institutional’  model  of  supervision  attributes  competences  or  powers  to  a 
regulatory  body  depending  on  the  type  of  financial  institution  subject  to  supervision.  The 
legal classification of the institution, for instance, whether it is defined as a bank or credit 
institution, investment or securities firm, or insurance company, determines which regulator 
has competence to supervise it. Where the institution is authorised to engage in a number of 
different financial activities, the regulator is empowered to supervise all these activities. 

The integrated approach generally involves a regulator with full or consolidated authority to 
supervise all financial institutions and approved individuals in the financial sector regarding 
their discharge of all functions in the financial services industry. The integrated model was 
popular in the 1990s with many countries (i.e. UK, Korea, Japan and Germany) adopting it 
because of the perceived synergies that a single regulator would have in supervising financial 
markets that were becoming increasingly integrated and liberalised79.   

The twin peaks approach involves the division of supervisory powers between (usually) two 
regulators:  one  with  responsibility  for  financial  stability  including prudential  supervision  of 
financial  institutions,  and  the  other  responsible  for  conduct  of  business  and  investor  and 
consumer protection in the marketing and sale of securities and other financial products. The 
twin  peaks  approach  has  become  increasingly  used  by  countries  post-crisis  because  the 
financial  crisis  demonstrated  the  importance  of  having  one  regulatory  authority  solely 
devoted  to  financial  stability  and  another  regulator  with  responsibility  for  investor  and 

78   See Ferran, 2015, pp.99-128. See also Group of Thirty, 2008. 
79   Briault, 1999.  

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consumer protection in light of the scandals involving mis-selling of investments and financial 
products 80. And in some countries, the twin peaks approach has taken a new dimension as 
regulators  are  given  some  responsibility  for  ensuring  competition  in  the  financial  services 
industry. 

Although some states have adopted a version of one of the above models in practice, most 
states  have  experimented  with  hybrid institutional  forms  that  are  the  product  of  historical 
evolution  and  the  design  of  constitutional  structures  (i.e.  federalism)  and  the  design  of 
economic  and  financial  institutions81.  States  are  continuing  to  experiment  with  different 
institutional structures of supervision post-crisis as they did prior to the crisis. No one size 
appears to be optimal for all countries, as financial, legal and political systems vary between 
states. 

The European Union embarked on a major institutional restructuring of financial regulation 
by  creating  a  European  System  of  Financial  Supervision  (ESFS)  consisting  of  three  micro-
prudential supervisory authorities – the European Banking Authority, the European Securities 
and Markets Authority and the European Insurance and Occupational and Pension Authority – 
and a European Systemic Risk Board (ESRB) to conduct macro-prudential oversight of the 
European financial system82.  

Although the sectoral approach to financial regulation may be appropriate for the European 
Supervisory Authorities, it is not necessarily the most appropriate approach at the level of 
Member  States.  The  crisis  has  taught  us  that  the  supervisors  responsible  for  prudential 
oversight and financial stability should be independent – and institutionally separate – from 
the  supervisors  responsible  for  investor  and  consumer  protection.  This  is  because  the 
objectives of financial stability and investor or consumer protection can diverge and in some 
cases may conflict. Accordingly, in the European Union, a fundamental principle should be 
adopted  at  the  Member  State  level  that  the  consumer  protection  agency  should  be 
separated from the supervisory agency in charge of financial stability. This principle 
is justified for the same reasons that in most Member States the competition authority should 
stand separate from the financial stability agency because, on occasion, their objectives may 
conflict. In the United States, the Dodd-Frank Act of 2010 created an independent Consumer 
Financial  Protection  Bureau  (CFPB)  with  enforcement  powers  while  in  the  UK  the  new 
Financial  Conduct  Authority  (FCA)  also  has  consumer  protection  in  its  remit.  However,  in 
most EU Member States, the prudential supervisor is typically also responsible for consumer 
protection.  This  report  recommends  that  the  EU  encouraged  Member  States  to  create  an 
independent agency along the lines of the US CFPB with independent enforcement powers. 
Because of the EU Treaty doctrine of conferred powers and the principle of subsidiarity, it is 
most appropriate legally not to create an EU agency with strong enforcement powers to bring 
legal actions representing aggrieved financial consumers. This power should be exercised at 
the Member State level.  

80   Taylor, 1995; and Taylor, 2009. 
81   Ferran, 2015, 100. 
82   Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on European 
Union macro-prudential oversight of the financial system and establishing a European Systemic Risk Board OJ L 
331.  See  Green  and  Jennings-Mares  (2014),  p. 3.  https://media2.mofo.com/documents/140106-regulatory-
reform-in-europe.pdf. 

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  ENDOWMENT INSURANCE PRODUCTS  

KEY FINDINGS 

Insurance-based investment products (IBIPs) expose retail investors to the risk of capital 
loss subject to market fluctuations. However, they are regulated as insurance products 
because their value is linked to capital life insurance, unit-linked life insurance and hybrid 
products.  IBIPs  generally  are  not  subject  to  MiFID II  regulatory  controls  on  product 
regulation, conflicts of interests and remuneration. Instead, IBIPs have been subject to 
lighter  touch  regulation  under  the  Insurance  Mediation  Directive  which  contains  only 
minimum restrictions on the design and distribution of products and minimal restrictions 
on remuneration. 

The  EU  approach  to  regulating  the  marketing  and  distribution  of  financial  products  is 
piecemeal and lacks  common concepts  and terminology. MiFID II should perhaps have 
covered  also  insurance-based  investment  products  (generally  considered  to  be 
substitutes to certain financial instruments).  

The EU sectoral approach to regulating differently functionally equivalent investment 
products  with  similar  economic  characteristics  should  be  reconsidered,  as  different 
regulatory  approaches  for  these  products  lead  to  segmentation  risk  and  regulatory 
arbitrage. 

Insurance-based  investment  products  (IBIPs)  are  also  known  as  endowment  insurance 
products. The Packaged Retail Investment Insurance Products (PRIIPs) Regulation introduced 
the technical term  IBIPs to insurance law. The PRIIPs Regulation requires that the sale  of 
such products be accompanied by a Key Information Document (KID) that describes the risks 
and is not misleading83. IBIPs expose retail investors to the risk of capital loss (directly or 
indirectly) subject to market fluctuations. However, they are also often linked to capital life 
insurance,  unit-linked  life  insurance  and  hybrid  products.  This  type  of  investment  product 
acknowledges that life insurance  contracts cover biometric risks and frequently contain an 
investment component (with risks and opportunities) intended to offer value to policyholders 
both in the event of death and survival. 

The  PRIIPs  Regulation  defines  IBIPs  as  insurance  products  which  offer  ’a  maturity  or 
surrender value and where that maturity or surrender value is wholly or partially exposed, 
directly  or  indirectly,  to  market  fluctuations‘.  IBIPs  generally  are  not  subject  to  MiFID II 
regulatory controls on product regulation, conflicts of interests and remuneration. Instead, 
IBIPs  have  been  subject  to  lighter  touch  regulation  under  the  Insurance  Mediation 
Directive (IMD), which contains only minimum restrictions on the design and distribution 
of  products  and  minimal  restrictions  on  remuneration.  The  IMD  will  be  replaced  by  the 
Insurance Distribution Directive (IDD) in October 2018. 

Under both PRIIPs and the IDD, there is an obligation for the issuer of IBIPs to produce a 
KID and additional requirements for distribution stipulated in the IDD Implementing Act that 
covers advice and sales. MiFID II and the  IDD  have similar principles for the  regulation of 
product  design  and  distribution,  such  as  the  general  duty  to  act  honestly,  fairly,  and 
professionally in accordance with the customer’s best interests (Article 17(1) IDD reflecting 
Article  24(1)  MiFID II).  Although  they  contain  similar  principles,  there  are  significant 

83   See  Commission  Delegated  Regulation  (EU)  2017/653.  The  Commission’s  Delegated  Regulation  for  PRIIPS 
requires that the KID is limited to three pages and must contain a description of 1) purpose, 2) the product, 3) 
what  are  the  risks  and  expected  returns,  4)  what  if  the  underlying  PRIIPS  issue  is  unable  to  pay  out  to  the 
investor, 5) What are the costs, 6) How long must the investor hold the product before selling it and 7) complaints 
procedure. 

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differences between MiFID II and IDD. There are higher protections under MiFID II. For 
instance, IDD has no separate conduct of business rule on product governance (equivalent 
to Article 24(2) MiFID II). Also, MiFID II and IDD have different conduct of business rules for 
inducements, independent advice, and investor protection. 

Regarding  inducements84,  MiFID II  prohibits  all  inducements  with  limited  exceptions, 
whereas the IDD permits insurance intermediaries/undertakings to receive inducements so 
long as it is part of ‘fulfilling their obligations’ to their customers and if not detrimental to the 
quality of service and duties to act honestly, fairly, and professionally in the customer’s best 
interests. The  IDD provides minimum harmonisation in this area  while Member States are 
allowed  to  have  stricter  ‘super-equivalent’  provisions  along  the  lines  of  the  UK  Retail 
Distribution Review. 

Regarding  ‘independent  advice’85,  MiFID II  has  strict  rules  regarding  disclosure  to  the 
customer about whether the adviser is providing independent advice. Moreover, the provision 
of independent advice must involve advice on a wide variety of products, and also comply 
with  the  inducements  regime  (Article  24(7)  MiFID II).  In  contrast,  the  IDD  has  minimum 
harmonisation  rules  on  the  provision  of  independent  advice  and  Member  States  are  not 
required to restrict inducements (i.e., bonuses) for the provision of independent advice.   

Moreover, for investor protection, MiFID II has a much stricter distinction between retail and 
professional  investors  and  limits  the  ability  of  the  firm  to  upgrade  a  retail  investor  to 
professional investor status unless certain assessments are completed regarding investor’s 
suitability to be treated as a professional investor. In contrast, the IDD has no such distinction 
between  retail  and  professional  investor.  This  is  a  significant  difference  in  treatment 
regarding the sale and distribution of MiFID II products and IBIP products governed under 
the IDD.  

This  sectoral  approach  to  regulating  investment  products  that  have  similar  characteristics 
and investment functions is highly questionable and should be reconsidered by policymakers. 
This  hampers  creation  of  a  true  level  playing  field  for  all  investment  products.  Also, 
supervision is sectorally divided (MiFID: ESMA /IDD: EIOPA) between two of the European 
Supervisory Authorities.  

In addition, there  are gaps in the EU legislative and regulatory regime. The EU  regulatory 
approach  is  piecemeal  and  lacks  common  concepts  and  terminology.  MiFID II  should 
perhaps have covered also IBIPs (generally considered to be substitutes to certain financial 
instruments  and  structured  deposits  which  are  subject  to  MiFID II’s  conduct  of  business 
rules). These differences can lead to segmentation risk and to regulatory arbitrage. 

84   Colaert, 2017 b, p.596. 
85   Colaert, 2017 b, p.597. 

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  CLOSET INDEXING 

ESMA defines ’closet indexing‘ as a ’practice of fund managers claiming to manage portfolios 
actively when in reality the fund stays close to a benchmark‘ 86. This essentially involves fund 
managers charging their clients for actively managing their investments when in fact all they 
are doing is ‘hugging’ an index (‘index-hugging’). ESMA believes that index-hugging harms 
investors as they are ’not receiving the service or risk-return benefits they expect based on 
the  fund’s  disclosure  documents  while  potentially  paying  higher  fees  compared  to  those 
typically charged for passive management‘ 87. The  German regulator BaFin has stated that 
this practice could be a problem of providing ’false or misleading information‘88.  

ESMA published on 2 February 2016 a Statement of its work on closet index tracking funds 
and its research on the topic. It studied 2 600 funds for the period 2012-2014. It observed 
based on investor disclosure documents that between 5 % and 15 % of UCITS equity funds 
could potentially be closet indexers89. It also found that on average nearly 30 % of gross 
fund return went to ongoing fees, one-off charges and inflation90. 

Investigations of Closet Trackers  

6.1. 
Several national competent authorities have conducted investigations of closet indexing. The 
German BaFin states that they did not detect any cases but they nonetheless call for more 
transparency 91. Luxembourg’s Commission de Surveillance du Secteur Financier CSSF stated 
in 2017 that no UCITS  domiciled fund in Luxembourg  was identified as  engaging in closet 
indexing, with the exception of one case of closet indexing under investigation92. The French 
Autorité des Marchés Financiers (AMF) stated that French-domiciled funds were reviewed and 
based on the ESMA analysis were not closet tracker funds93. And the UK Financial Conduct 
Authority (FCA) undertook a review in 2017 of 84 potential closet tracker funds and in 2018 
demanded  changes  from  64  of  those  funds,  in  which  the  fund  managers  were  required  to 
make  it  clearer  to  consumers  that  they  were  very  ‘constrained’  in  actively  managing  their 
customers’  investments  because  they  were  tracking  or  ‘hugging’  an  index,  rather  than 
actively  managing  their  customers’  funds.  These  funds  were  also  required  to  pay  GBP  34 
million  in  compensation  to  investors  because  they  were  charging  them  for  active 
management  while  in  reality  they  were  following  a  constrained  decision-making  approach 
that mainly involved tracking an index94. For example, the FCA found that seven key investor 
information documents (KIIDs) lacked clear descriptions of how funds were managed; five 
of which ’used a benchmark-related approach that should have been disclosed’95. 

The  consumer  advocacy  group  Better  Finance  in  February  2017  replicated  the  above 
mentioned ESMA study and found that up to 165 equity UCITS funds to be potential closet 
indexers96. ESMA estimates that about 33 % of potential closet indexers do not disclose their 
benchmark’s performance alongside their own performance in their KIID, and that this does 
not  comply  with  UCITS IV.  As  a  result,  ESMA  calls  for  more  transparency  on  reasons  for 

86   ESMA. 
87   ESMA. 
88   BaFin, news. 
89   ESMA, 2016, p. 3. 
90   Jones, 2017, p. 4. 
91   BaFin, 2016, p. 3. 
92   Jaminon. 
93   Paredes-Vanheule. 
94   Butler, 2018. 
95   FT Advisor, 2016, p. 1. 
96   Better Finance used the same database (Morningstar as ESMA). See Better Finance, 2017. 

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charging ’active‘ fees, and for more transparency on the part of ESMA and NCAs regarding 
fund’s metrics and for further monitoring and investigations97. 

Better Finance also compiled a list of asset managers, which have potentially sold closet index 
funds,  including  Henderson,  Fidelity,  JP  Morgan  and  Schroders.  This  demonstrates  that 
improvements can be made. For instance, investor disclosure on the use of benchmarks 
(e.g.  in  KIID  and  prospectus).  ESMA  announced  it  will  complete  a  study  of  fees  and  past 
performance of mutual funds by late 201898 and that it would publish guidance in 2019 on 
’stress  testing‘  of  mutual  and  alternative  investment  funds  to  check  if  they  can  withstand 
severe market shocks99. 

97   Statement  of Guillaume  Prache,  Managing  Director  of  Better Finance:  ‘These findings  are  clear proof  that  EU 
regulators  must  not  eliminate  the  standardised  disclosure  of  the  long-term  and  relative  past  performance  of 
retail investment products to their benchmark, as they unfortunately plan to do in the implementing rules for 
Priips.’ FT Adviser. 

98   Jones, 2017. 
99   Jones, 2017. 

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  CONCLUSION 

This paper argues that the EU regulation of retail financial products and related investment 
services suffers from segmentation risks and regulatory arbitrage opportunities for 
financial  institutions  to  design  risky  financial  products  that  attract  minimum 
regulatory  protections.  Rather  than  applying  similar  regulatory  standards  to  these 
products, the EU legislative and regulatory framework treats these products with similar risk 
features significantly different in terms of regulatory requirements and therefore creates an 
uneven  regulatory  playing  field  resulting  in  segmentation  risks  between  different  financial 
sectors. This situation can also lead financial institutions to engage in regulatory arbitrage as 
the design of investments is driven mainly by regulatory compliance considerations, rather 
than by economic factors, such as the risk adjusted return for customers. EU draft legislation 
(UCITS VI)  shows  that  progress  is  possible  in  this  area.  The  paper  suggests  that  EU 
policymakers should call for an alignment in requirements for the marketing, sale and 
distribution (along with similar product intervention powers) of all financial products sold in 
the EU to retail customers. This would require revising the existing EU laws governing the 
sale and distribution of financial and investment products across the  different EU financial 
sectors.  It  would  also  require  that  the  three  European  Supervisory  Authorities  work 
closely together in implementing existing and new legislation to address regulatory gaps, 
segmentation  risks,  and  arbitrage  opportunities.  One  way  to  enhance  ESA  coordination  in 
this area would be to involve the Joint Committee of the European Supervisory Authorities, 
consisting  of  representatives  of  the  three  ESAs,  to  facilitate  the  adoption  of  regulatory 
technical  standards  and  technical  guidance  for  Member  States  to  apply  in  their  regular 
supervision.  

The  paper,  however,  concludes  that  implementing  a  more  harmonised  legislative  and 
regulatory framework governing the marketing, sale and distribution of financial products will 
be  challenging.  Addressing  segmentation  risks  and  regulatory  arbitrage  will  be  difficult  to 
eradicate  in  the  financial  product  markets  especially  because  of  the  potential  for  financial 
institutions to design different products that fall outside regulatory parameters, particularly 
regarding their risk characteristics. Also, reforms to promote a more harmonised system of 
laws and regulations governing the sale and distribution of financial products will be difficult 
to  address  so  long  as  the  EU  continues  to  follow  a  sectoral  approach  to  regulating  these 
products.  Finally,  the  paper  also  points  out  related  regulatory  concerns  in  the  asset 
management industry concerning closet-index funds that are charging customers for active 
asset  management  but  instead  are  only  linking  their  assets  to  the  performance  of  index 
funds.  The  paper  raises  the  question  of  whether  this  should  be  classified  as  a  form  of 
misrepresentation and discusses recent regulatory investigations and suggests that further 
supervisory attention to this issue should be given. 

The report also recommends that the institutional design of financial regulation in EU Member 
States should be based on the principle that the consumer financial protection agency 
should  be  separate  institutionally  from  the  supervisory  agency  in  charge  of 
prudential  supervision or financial stability. The  rationale for this is similar to that in 
most Member States where the competition authority is separated from the financial stability 
agency because, on occasion, their objectives may conflict. In the United States, the Dodd-
Frank  Act  of  2010  created  an  independent  Consumer  Financial  Protection  Bureau  with 
enforcement powers whose governance and decision-making authority is separate from the 
agencies  responsible  for  banking  supervision.  However,  in  most  EU  Member  States,  the 
prudential  supervisor  is  typically  also  responsible  for  consumer  financial  protection.  The 
report suggests that the agency  responsible for  consumer financial protection  should be  a 
standalone  agency  whose  tasks  could  be  coordinated  or  integrated  with  the  competition 
authority. 

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As an epilogue, this paper has considered the European Commission’s draft proposals for a 
’New Deal for Consumers’ package that was proposed in April 2018 just after this paper was 
finalised.  Specifically,  the  Commission’s  draft  Directive  on  representative  actions  for  the 
protection of the collective interests of consumers was reviewed in which ’qualified entities‘ 
would  be  authorised  to  bring  a  representative  action  before  a  Member  State  court  or 
administrative  authority  on  behalf  of  classes  of  consumers  who  have  suffered  losses  for  a 
trader’s violation of EU consumer protections laws. Redress for retail customers of banking 
or  financial  institutions  would  be  available  where  the  bank  or  financial  services  firm  was 
shown to have breached prescribed EU financial services legislation. This paper welcomes the 
Commission’s draft Directive because it would provide additional procedural avenues for retail 
financial customers to assert their rights against financial institutions which have breached 
EU financial law and to obtain compensation or other adequate redress. However, the paper 
concludes that such legislation would not be effective unless accompanied by wider ranging 
reforms of EU financial services law to reduce the segmentation risks and regulatory arbitrage 
opportunities discussed in this paper. Also, qualified entities will be ineffective in asserting 
claims on behalf of retail financial customers if they do not have an independent and proactive 
consumer  financial  protection  institution  to  work  with  at  the  Member  State  level.  For  the 
Commission’s  draft  Directive  on  representative  actions  to  be  effective,  it  must  be 
accompanied by legal and regulatory reforms as discussed elsewhere in this paper. 

32 

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38 

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This study forms part of a series of five studies on mis-selling of financial products in the EU. The study reviews 
the EU legislative and regulatory framework for the marketing, sale and distribution of financial products to 
assess whether post-crisis EU regulatory reforms have met their objectives and, if not, what are the gaps and 
weaknesses  in  the  current  EU  regulatory  approach.  The  EU  follows  a  sectoral  approach  to  regulating  the 
marketing and sale of financial products, which results in segmentation and arbitrage risks. The paper argues 
that the European Supervisory Authorities should adopt more harmonised regulatory and technical standards 
to reduce these risks and ensure more effective enforcement by Member State authorities. This document was 
provided by Policy Department A at the request of the ECON Committee.  

PE 618.996 
IP/A/ECON/2016-17 

Print  
PDF 

ISBN 978-92-846-2919-0 | doi:10.2861/003681 | QA-01-18-481-EN-C 
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