ESMA Guidelines on suitability

The objective of the revised ESMA Guidelines on suitability requirements is to promote a uniform and consistent implementation of the recently amended MiFID II requirements such as i) integrating a client’s sustainability preferences as a top up to the suitability assessment and ii) integrating sustainability risks into the organisational requirements.

The final Guidelines were published on 23 September 2022 and are being currently translated into the official languages of the EU. They’ll become applicable six months after the date of the publication on ESMA’s website in all EU official languages. Thus, most probably the Guidelines will apply as of July 2023.

Background

The assessment of suitability is one of the most essential elements for investment protection in the MiFID II framework. It applies to the provision of any type of investment advice (whether independent or not) and portfolio management. Investment firms providing investment advice or portfolio management have to provide suitable personal recommendations to their clients or have to make suitable investment decisions on behalf of their clients. The suitability evaluates a client’s knowledge and experience, financial situation (incl. ability to bear financial losses) and investment objectives (incl. risk tolerance). To this end, investment firms have to obtain the necessary information from the client or potential client.

On 27 January 2022, ESMA launched a public consultation on the Guidelines and collected responses from relevant stakeholders until 27 April 2022. ESMA initiated the review of the 2018 Guidelines in order i) to incorporate the sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms emerging from the amended MiFID II Delegated Regulation applicable from 2 August 2022; ii) to address the shortcoming evaluated in the Common Supervisory Action (CSA) on the application of MiFID II suitability requirements and consequently to complement the existing Guidelines with the good and poor practices identified by the CSA and iii) to reflect the switch proposal requirements introduced through the Capital Markets Recovery Package.

By the publication of the revised Guidelines, ESMA aims to:

• reduce the risk of mis-selling
• eliminate greenwashing in the distribution of investment products with sustainability features
• reduce the risks of regulatory and supervisory arbitrage and achieve positive effects from increased harmonisation and standardisation for investment firms and competent authorities.
  

Key concepts of the ESMA Guidelines

The Guidelines are structured in four clusters and although they focus on the topic of sustainability, some further important aspects such as switch proposals and record-keeping duties are clarified. With the implementation of these Guidelines, ESMA believes that improved investor protection will be achieved.

I. Information to clients about the purpose of the suitability assessment and its scope

Guideline 1: Information about the suitability assessment 

ESMA provides some clarifications about how firms should inform their clients about the suitability assessment and its purpose. Even though there are no strict requirements regarding the format of information, it’s highlighted that the investment firms should implement controls to check whether the information has been provided. 

Special attention should be paid to the concept of ‘sustainable preferences’. Thus, firms should explain the terms and distinctions between the different elements of the definition of sustainable preferences and between products with and without such sustainability features. 

ESMA makes some special recommendations to firms providing services through robo-advice, where additional information requirements need to be met. 

II. Know your client and know your products

Guideline 2: Arrangements necessary to understand clients

Firms must establish, implement and maintain adequate policies and procedures (including appropriate tools) to enable them to understand the essential facts and characteristics about their clients. ESMA makes some concrete recommendations for the firms using questionnaires to collect the relevant information. In addition, it provides examples of clients’ circumstances which need to be considered while analysing the clients’ financial situation and investment objectives.

The Guideline also introduces specifications regarding the duty to collect information on sustainability preferences, i.e. information on:

• whether or not the client has sustainability preferences, if ‘Yes’ then
• information on the client’s focus on either environmental, social or governance criteria or a combination of them, or whether the client doesn’t have such a focus
• information on the client’s preferences in terms of ‘minimum proportion’ (i.e. percentage or by range)
• information on which principal adverse impacts (PAI) should be considered including qualitative or quantitative criteria demonstrating that consideration.  

Guideline 3: Extent of information to be collected from clients (proportionality)

It’s specified that the extent of information to be asked about a client’s knowledge and experience, financial situation and investment objectives may vary due to the features of the investment advice or portfolio management services to be provided, the type and characteristics of the investment products and the characteristics of the clients. 

In general, the granularity of the information to be collected depends on the type of the financial instrument, nature and extent of the provided financial service, type of client and the needs or circumstances of the client. Consequently, more in-depth information is required for complex, risky or illiquid financial instruments or for potentially vulnerable clients (e.g. older clients). 

Guideline 4: Reliability of client information

ESMA stipulates that firms should take reasonable steps and have appropriate tools to ensure that the information provided by the clients is reliable and consistent without excessively relying on clients’ self-assessment. It’s outlined that the firms should implement measures and controls to check the reliability and accuracy of the information collected for or provided by the clients.  

Guideline 5: Updating client information

Firms having an ongoing relationship with the client (i.e. proving ongoing advice or portfolio management services) shall adopt procedures defining which elements of the client’s information and with what frequency should be regularly updated and what actions need to be undertaken when updated information is received, additional information is necessary or the client doesn’t provide the required information. 

In case the additional information leads to a change in the client’s risk profile, the firms should inform the client accordingly by explaining whether the risk profile is becoming more risky or more conservative.

The information regarding the sustainability preferences of a client should be updated at the latest through the next regular update of client information. Until then, the firms should treat these clients as being ‘sustainability-neutral’. Consequently, the client can be recommended products with and without sustainability features. 

Guideline 6: Client information for legal entities or groups

ESMA outlines that firms must implement a policy defining on an ex-ante basis how to conduct the suitability assessment in situations where the client is i) a legal person, ii) a group of two or more natural persons or iii) where one or more natural persons are represented by another natural person. In addition, it’s specified how the firm should inform ex-ante those of its clients about the firm’s approach and its impact on the way the suitability assessment is done. 

The firm’s policy should make a clear distinction between situations where a representative is foreseen under applicable law and situations where no representative is foreseen. 

Guideline 7: Arrangements necessary to understand investment products

In order to understand the characteristics, nature and features (including costs and risks) of investment products and how they can behave under different circumstances, firms should implement policies and procedures which allow them to recommend suitable investments, or invest into suitable products on behalf of their clients. 

III. Matching clients with suitable products

Guideline 8: Arrangements necessary to ensure the suitability of an investment

Firms should establish policies and procedures in order to match clients with suitable investments. To ensure this, ESMA outlines that the policies should consider all available information about the client necessary to assess whether an investment is suitable (including current portfolio and assess allocation) and all relevant characteristics of the investments considered in the suitability (including risks as well as direct and indirect costs).

It's specified that the sustainability preferences should only be taken into account once the suitability has been assessed in line with the criteria of i) knowledge and experience, ii) financial situation and iii) investment objectives. Thus, in a first step the range of suitable products is identified and in a second step the products meeting the client’s sustainability preferences are determined.

Special provisions are defined also with regard to suitability assessments conducted through automated tools. It’s specified that the investment firms should monitor and test the algorithms that underpin the suitability on a regular basis. 

Guideline 9: Costs and complexity of equivalent products

A firm’s suitability policies and procedures should ensure that, before a firm makes a decision on the investment product(s) that will be recommended or invested in the portfolio managed on behalf of the client, a thorough assessment of the possible investment alternatives is undertaken, taking into account products’ cost and complexity.

ESMA states that the investment firms should implement a process assessing the ‘equivalence’ of the products considering all costs and charges as well as the complexity of the different products. Firms are expected to be able to justify those situations where a more costly or complex product is recommended over an equivalent product. These decisions should be documented by the firms and are subject to increased control activities.

Guideline 10: Costs and benefits of switching investments

Investment firms are supposed to have in place adequate policies and procedures to ensure that a cost-benefit analysis of a switch is conducted enabling them to demonstrate that the expected benefits are greater than the costs.  

The Guidelines stress that firms should consider all necessary information in the cost-benefit analysis of the switch, i.e. an assessment of the advantages and disadvantages of the new investment(s). When considering the cost dimensions, firms should take into account all costs and charges as defined by article 24(4) MiFID II and the related MiFID II Delegated Regulation. The costs and benefits should cover both monetary and non-monetary factors (e.g. expected net return of the proposed new investment compared to the expected net return of the existing investment; a change in a client’s circumstances or a product’s features; benefits arising from the switch such as increased diversification or increased alignment with the portfolio’s risk profile). The suitability report should explicitly explain whether the benefits of the recommended switch are greater than its costs and has to be provided to the retail client before the transaction is made.

Furthermore, firms should adopt controls to monitor the risk of circumventing the obligation to assess the costs and benefits of switch proposals. 

IV. Other related requirements

Guideline 11: Qualifications of firm staff

It’s highlighted that firms should take appropriate measures to ensure that staff involved in the suitability assessment process has an adequate level of skills, knowledge and expertise. Specific trainings are required regarding sustainability preferences to enable a firm’s employees to explain the different aspects in non-technical terms and in an unbiased manner.

Guideline 12: Record-keeping

ESMA clarifies that firms should have record-keeping arrangements in place, which enable them to track ex-post why a (dis)investment was made and why investment advice was given even when the advice didn’t result in an actual (dis)investment. To this end, firms are required to record all relevant information such as i) information about the client (including how information is interpreted to define the risk profile); ii) information about the financial instruments recommended to the client or purchased on the client’s behalf; iii) suitability report provided to the client; iv) any changes made in the client’s risk profile; v) types of products that fit the profile and the rational for such assessment and vi) situations where the client’s sustainability preferences are adapted (including rational).

Besides the 12 Guidelines, ESMA provides an overview of good and poor practices and thus gives some practical guidance to firms in the areas where lack of convergence still seems to persist. 

Impact on Swiss financial service providers

While the Guidelines have a direct impact on EU/EEA investment firms providing investment advice and portfolio management services, they also apply to Swiss-based firms carrying out the said services to clients domiciled in the EU or EEA.

How can we support you?

Would you like to better understand the impact of the new Guidelines on your business, or do you need support in the implementation of the new regulatory requirements? Please don’t hesitate to contact us.