On the Sustainability of the MiFID II and IDD Investor Protection Frameworks

Multiple studies have shown a gap between investors’ intentions and preferences on the one hand, and their actual behaviour on the other hand (‘value-action-gap’).  This gap has been attributed to a lack of notoriety and availability of ESG products, and, when investors do have access to ESG products, a perception of high volatility and less profitability of ESG investments. The ESG disclosure obligations introduced by the Corporate Sustainability Reporting Directive and the Sustainable Finance Disclosure Regulation (‘SFDR’), are an important part of the regulatory response to the lack of availability of ESG-information of investment products, and should help in increasing the notoriety of ESG products. However, disclosure requirements alone may not suffice to reorient retail investor capital towards sustainable investment. Even when investors are well-informed and convinced of the benefits of ESG products, limited attention at the moment of decision-making and procrastination in respect of complex decisions—such as changing an investment strategy—explain why even correctly informed investors not always act upon their preferences. Investment product distributors can then play an important role in bridging the gap between the values of investors and their actual investment choices. They can raise knowledge and awareness of sustainable products at the very moment investors need to make a choice, thus helping to counter problems of bounded rationality, and, more particularly, the limited attention problem which has been defined as one of the main causes of the gap. 

In the wake of the Sustainable Finance Action Plan, the MiFID II and IDD conduct of business regimes have therefore been amended. In a recent contribution, I have evaluated those amended frameworks from three perspectives: (i) their contribution to remedying the ‘value-action-gap’ and to a more sustainable economy more generally; (ii) their contribution to the creation of a level playing field between economically similar investment products; and (iii) their coherence with other, closely related sustainable finance measures.

I came to the following conclusions.

1. Contribution to a More Sustainable Economy

The new obligatory questions about ESG preferences in the suitability assessment will undoubtedly help in closing the ‘value-action-gap’ between investors’ intentions and behaviour. They raise awareness of the options for investors to contribute to a more sustainable economy through their investment decisions and will ensure that (at least advised) investors do not miss out on ESG products because of limited attention for this segment. However, the definition of ‘sustainability preferences’ is needlessly complex. The obligation under the suitability test to explain to investors the terms of and the distinctions in the definition of sustainability preferences therefore seems an almost impossible task. It is in our view, moreover misguided and unnecessary. Rather than overwhelming investors with concepts that are difficult to grasp, investment intermediaries should ask them questions in layman terms. On the basis of their answers, it is up to the intermediary to qualify their sustainability preferences in terms of the different elements of the definition, without burdening the investor with complex upfront information. We doubt, moreover, that the emphasis on a suitability test in two phases—with a first selection of products on the basis of knowledge and experience, financial objectives and financial situation, followed by a second selection according to sustainability preferences—is legally sound, or even needed in order to avoid mis-selling.  We furthermore found that stronger measures are thinkable to boost sustainable finance, such as presenting sustainable investment products as default option, provided that the product also suits the other needs and objectives of the client. Such measures would, however, also give a paternalistic edge to the suitability assessment, and could lead to ‘stranded assets’.

The amended product governance requirements, which provide that product target markets need to describe the sustainability factors of the product in view of potential sustainability preferences of investors, are also an important step forward to avoid mis-selling and to allow for an efficient application of the suitability test. However, we regret that this requirement only applies if the product targets investors with sustainability preferences. To escape the extra target market obligations for sustainable products, product manufacturers may prefer to categorize their product as not targeting investors with sustainability preferences, even if the product does have sustainability factors (so-called ‘green bleaching’). Similarly, the possibility to ‘cluster’ target market descriptions—and thus reduce the cost of the product governance requirements—may induce firms to green bleach, so that products’ different ESG profiles would not prevent such clustering. It would have been preferable if, just as for the risk profile of a product, the regulator required that the ESG profile of each and every product be defined with a high degree of granularity. In this way ‘green bleaching’ for convenience purposes would be avoided, and product distributors would more easily find ESG-information on the products they offer.  

In regard of the amended MiFID II and IDD conflicts of interest regimes, we have expressed regret that the examples provided by ESMA and EIOPA did not make it to the recitals of the amending Regulations in order to provide further guidance to market participants.

2. No Cross-Sectoral Playing Field

In the explanatory memoranda of the Regulations and Directive amending the MiFID and IDD frameworks the Commission expressed its intention to integrate sustainability considerations into the investment, advisory and disclosure processes in a consistent manner across sectors. Despite these good intentions, reality proves very different. The notion ‘investment products’ is very broad, including not only financial instruments, but also insurance-based investment products, pension products, crowdfunding products and crypto-assets. However, only the MiFID II and IDD frameworks have been amended to integrate sustainable finance into the EU investor protection regimes. Neither the Crowdfunding Regulation, nor the Markets in Crypto-assets Regulation integrate sustainable finance in their investor protection regimes. The delay in integrating sustainable finance into those regulations, compared to the measures already taken in the MiFID- and IDD-frameworks, makes the uneven playing field which already existed between products, even worse. 

But even within the amended MiFID and IDD frameworks sustainability considerations have not been integrated in a consistent manner across sectors. On the contrary, sustainable finance amendments have created new differences between both regulatory frameworks, which the Commission does not justify, and which do not seem justified on the basis of differences between financial instruments and structured deposits on the one hand and insurance-based investment products on the other. This contribution has provided a number of striking examples. In most cases, the legal effect of both frameworks will still be more or less the same—even though further research on the implementation in practice of both regimes should confirm this. Nevertheless, the differences create legal uncertainty and make the practical implementation process of both regimes different, which is inefficient. It stresses the difficulty of creating a level playing field between economically very similar products in separate legal frameworks. Even if the legislator succeeds in drafting relatively similar Level 1 texts—as is the case for the MiFID and IDD suitability regimes, it is almost impossible to keep this up at levels 2 and 3, and even more difficult when levels 1, 2 or 3 are amended at a later stage.  The different level 3 guidance on suitability provided respectively by ESMA and EIOPA serves as further proof of this statement—and is particularly worrying. We have argued before that it would make more sense to include insurance-based investment products in the MiFID framework. The current need to adapt both regimes in accordance with the Sustainable Finance Action Plan underlines the inefficiency of maintaining two separate regimes for economically similar products.

3. Uneasy fit with Taxonomy and SFDR

Crucial in the amended MiFID II and IDD frameworks is the new definition of ‘sustainability preferences’. The definition refers to three product categories, which explicitly and implicitly refer to concepts of the Taxonomy Regulation and the SFDR and are not easy to disentangle. It takes quite some expertise to delineate and comprehend what those categories exactly cover and how they relate to the products subject to article 8 and article 9 SFDR. In the paper, I have visualised (i) the relationship between the three product categories in the definition of sustainability preferences, and (ii) the relationship between those product categories on the one hand and article 8 and 9 SFDR on the other hand. Many difficult interpretation questions remain. The fact that the product categories in the definition of sustainability preferences to a large extent overlap, does not help. As mentioned above, it makes the obligation under the suitability test to explain to investors the terms and the definition of sustainability preferences, an almost impossible task.

The amended MiFID and IDD obligations are moreover shaped by systematic references to sustainability risks and factors, which are defined in terms of environmental, social and employee matters, events or conditions. A key question which remains unsolved, however, is how these three elements (E, S and G) are to be understood. So far, the Taxonomy Regulation only determines when an investment or activity can be considered as environmentally sustainable. However, due to a lack of reliable data, it is often very difficult to correctly assess the (degree of) sustainability of products or activities. Moreover, to comply with the revised MiFID II and IDD investor protection frameworks, financial services providers also need to determine whether an investment can be considered as sustainable from a social or governance perspective. They therefore typically make use of sustainability ratings or national labels to assess the sustainability of products or companies. However, those labels and ratings differ in content and quality and are, so far, unregulated. Moreover, separate data on the three elements (E, S and G) is often not available, further complicating the implementation of the amended MiFID II and IDD frameworks.  The resulting situation is far from ideal: it increases the cost of compliance, causes uncertainty, and leads to different implementations by different financial institutions. This leads to a lack of comparability and transparency of products and services—two basic conditions to achieve adequate investor protection, and indeed explicit objectives of the EU’s sustainable finance policy.

Veerle Colaert is Professor of Financial Law at KULeuven and UHasselt.

The article can be read here.