Passporting

When we published the RDR Discussion Paper in June (Discussion Paper 07/1), we explained that any new regulation arising from the RDR, or the removal of regulatory barriers, will need to be compatible with the requirements of relevant EU Directives. As we set out in the Discussion Paper, we are determined to improve outcomes for consumers and will therefore consider all practicable means of achieving the aims of this review. But at this stage of the review we are still a long way from firming up on precisely what market-led solutions are needed and even further away from determining the regulatory framework to enable these solutions to deliver their intended outcomes. Therefore it is too early to speak of MiFID or indeed of any other directive as a barrier for the RDR.

As we said in the Factsheet, whether you will need a passport to advise clients in other EEA States is first and foremost a matter of the law of those other EEA States. So the question of whether a client's tax residence is relevant to whether their financial adviser needs a passport is a matter for the law of the other EEA State where the client is based. We cannot give guidance on the law of those other countries, so you may wish to take professional advice if you think your business is likely to be affected by these issues.

Subject to this, we note in our Factsheet that where an adviser is actively contacting clients while they are in another EEA State it may well be providing cross-border services (regardless of the clients' tax residence status).

There is no settled European view yet on how the MiFID and Insurance Mediation Directive passports work in the case of an insurance product such as an investment bond linked to any underlying funds that might be MiFID investments. So, for the moment, a firm may wish to check that the Host State in question agrees which of the passports is relevant in the circumstances, if any.

As unit trusts are MiFID financial instruments, 'investment advice' and 'reception and transmission' services relating to them would fall within the scope of MiFID. This could, for example, include services such as making a personal recommendation to a client in connection with the underlying funds or arranging the switching of these funds. In these instances the firm may require a MiFID passport. For further details about 'personal recommendations' and reception and transmission, see Chapter 13 of our Perimeter Guidance Manual (Q13, 14, 19-21).

Yes, firms who are covered by the Article 3 exemption but who choose to opt into MiFID will become what are known as 'exempt CAD firms' in our Handbook. This means that these firms may have to maintain higher financial resources than they did previously although they will not be subject to the full requirements of the Capital Requirements Directive.

In our Financial Advisers and Passporting factsheet, we explained the financial resources test and requirements for firms opting into MiFID. We outline the key new requirements below with some additional information about the application of the tests.

Initial capital/ PII requirements

Exempt CAD firms subject to the Insurance Mediation Directive (IMD):

PII equal to that of the IMD requirements (i.e. minimum limits of indemnity per year of €1,000,000 for a single claim and €1,500,000 in the aggregate) plus additional resources in one of the following forms:

• Initial capital of €25,000; or
• PII of €500,000 for any one claim and €750,000 in aggregate; or
• A combination of initial capital and PII resulting in an equivalent level of coverage to the options above.

Where a firm opts for the second or third option, it must have initial capital of at least £10,000.

Exempt CAD firms not subject to the IMD must hold:

• Initial capital of €50,000; or
• PII of €1,000,000 for any one claim and €1,500,000 in aggregate; or
• A combination of initial capital and PII resulting in an equivalent level of coverage to the options above.

Where a firm opts for the second or third option, it must have initial capital of at least £10,000.

Exempt CAD firms must also meet ongoing capital requirements by maintaining a combination of PII and own funds at least equal to the requirements for PII and initial capital outlined above (see Interim Prudential Sourcebook for Investment Businesses (IPRU (INV)) 13.1A.13R).

Financial Resources tests

Exempt CAD Firms which, prior to 1 November 2007, were subject to the Adjusted Net Current Assets Test and the Expenditure Based Requirement (EBR) in IPRU (INV) 13.11 and 13.12 must continue to meet these requirements. The financial resources requirement for a personal investment firm which is an 'exempt CAD firm' is the higher of the requirement arising under the initial capital/PII requirements and the financial resources tests applying prior to 1 November 2007 (see IPRU (INV) 13.1A.2R). So in the case of an exempt CAD firm whose EBR is higher than the initial capital requirement outlined above, its financial resources requirement will correspond to its EBR.

A firm which was a 'low resource firm' before 1 November 2007 will continue not to be subject to the Adjusted Net Current Assets Test or the EBR, even if it becomes an exempt CAD firm. A 'low resource firm' for these purposes is a 'Category B3 firm' which is not a 'network', has fewer than 26 financial advisers or representatives and is not permitted to:

1. carry on discretionary portfolio management;
2. establish, operate or wind up a personal pension scheme; or
3. delegate the activities in (a) or (b) to an investment firm.

Generally, financial advisers will be subject to the IMD if they advise on insurance based products. If you are subject to the IMD you will still have to maintain the same level of PII in relation to your insurance mediation business and hold additional resources either in the form of initial capital or PII (as explained above).

If a financial adviser firm is not subject to the IMD the financial resources requirement can either be made up of initial capital or PII or a combination of both, although a minimum of £10,000 own funds must always be held. Therefore, if a firm decides to hold the full requirement in the form of own funds it would not have to hold PII.

Please refer to section 13 of the Interim Prudential Sourcebook for Investment Businesses (IPRU (INV)) for further information.

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Instead of being subject to the financial resources requirements as set out in the IPRU (INV) Handbook (Section 13), firms holding client money will be subject to the relevant requirements of the Capital Requirements Directive as transposed in the General Prudential Sourcebook (GENPRU) and The Prudential Sourcebook for Banks, Building Societies and Investment Firms (BIPRU). Firms will have to do what is known as an Internal Capital Adequacy Assessment Process (ICAAP) to assess their exposure to risk and calculate how much financial resources is needed to cover this. Therefore, whilst the firm may not have to maintain PII the financial resources requirements are much higher than if it did not hold client money and the overall prudential requirements are likely to be more onerous than for exempt CAD firms.

For further information please refer to the Capital Requirements Directive pages on the FSA website.

Similar to above, these firms will be subject to the relevant requirements of the Capital Requirements Directive as transposed in the General Prudential Sourcebook (GENPRU) and The Prudential Sourcebook for Banks, Building Societies and Investment Firms (BIPRU). Firms will have to do what is known as an Internal Capital Adequacy Assessment Process (ICAAP) to assess their exposure to risk and calculate how much financial resources is needed to cover this. Therefore, whilst the firm may not have to maintain PII the overall prudential requirements are likely to be more onerous than for exempt CAD firms.

For further information please refer to the Capital Requirements Directive pages on the FSA website.

Exempt CAD firms may only use long term subordinated loans which means that the loans must have an original maturity or notice period of at least 5 years (rather than the 2 years that is required for short term subordinated loans). Exempt CAD firms are also subject to a restriction on the amount of loans that can be used in its financial resources. Please refer to the IPRU (INV) Handbook for further information (specifically 13.1A.15R, 13.1A.17R and 13.5.5AR).

Exempt CAD firms will need to review their subordinated loans in line with the requirements and should contact the FSA if they need to make any changes.

Firms who opt into MiFID and become exempt CAD firms can still benefit from the small firms audit exemption as long as they continue to meet the requirements of the Companies Act legislation and the conditions of the article 3 MiFID exemption. For further information please refer to question 58 of the Perimeter Guidance Manual (PERG) 13.6.

Firms referred to as 'Exempt CAD Firms' will start their full new reporting from 31 August 2008 (under SUP 16.12.22AR). Until then, they will continue to submit their RMAR (under SUP 16.7.77R).

On the RMAR, firms will have to enter their amount of 'Own Funds' manually. Therefore, firms will need to be aware of what their requirement is and enter the appropriate amount which should be in sterling. Firms can do this by completing section D2 of the RMAR which breaks down the own funds calculation. Firms can then put the summary of these results into section D1.

Firms should ensure that they are able to comply with the new requirements at all times and should keep records to support this. Firms must notify the FSA if they are unable to meet these requirements.

This will be up to each individual firm to decide and a firm should consider its particular business model, including how it obtains its clients and whether there is a real intention to conduct business in a particular EEA State(s). Firms should be aware that they are likely to receive various requests for information from host state regulators in the EEA state(s) they have applied for that they will need to deal with. They may also be charged a fee by host state regulators. However, if a firm only applies for a passport to cover a limited number of states and subsequently wishes to provide cross-border services to a client in a state which is not covered by their passport they may not be able to do so until they have obtained a passport for that state.

A firm can add additional states to their passports by completing and submitting the relevant cross border notification form (MiFID or IMD) to the FSA, selecting the additional state(s) required. There is no charge for this and the passport should be confirmed and the FSA Register updated within 30 days.

For further information please read the FSA factsheet: Financial Advisers and Passporting.

If a firm states in its disclosure to customers that it will choose packaged products from the whole of market it must make sure that its consideration of product providers is 'sufficiently large' to satisfy the client's best interests and the fair, clear and not misleading rules. Clearly where the advice relates to a customer in another EEA state this requirement needs to be met. Furthermore, exempt CAD firms will still need to ensure that a personal recommendation is suitable for the customer. Therefore, in some circumstances, the firm will have to consider whether a UK product would be suitable for an overseas customer or whether they also need to consider products from an overseas state.

Yes, a firm that opts in to MiFID just to get a passport will still need to comply with COBS as a MiFID firm in respect of its UK investment business (including cross border service business from the UK).