MiFID II: are local government pension schemes at a disadvantage?

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

During his July 2015 budget speech, Mr Osborne announced that administering authorities under the Local Government Pension Scheme (LGPS) would be "encouraged" to pool funds to reduce costs and to have access to economies of scale which may be available to larger investment funds.

In his Conservative Party Conference speech, Mr Osborne went further, describing the proposed pooled funds as "British wealth funds" and stating that these funds will invest significant amounts in infrastructure projects.

"At the moment, we have 89 different local government pension funds with 89 sets of fees and costs.

"It’s expensive and they invest little or nothing in our infrastructure.

"So I can tell you today we’re going to work with councils to create instead half a dozen British wealth funds spread across the country.

"It will save hundreds of millions in costs, and crucially they’ll invest billions in the infrastructure of their regions.”

(Source: The Right Honorable George Osborne – Conservative Party Conference October 2015)

But, is the Chancellor’s irrepressible force about to meet an immovable object in the form of the EU directive – MiFID II?

What is MiFID II?

The second Markets in Financial Instruments Directive (MiFID II) builds on the original MiFID and is the framework of European legislation governing investment firms providing certain investment services to clients and the organised trading of financial instruments.

What is the issue for LGPS funds?

Under MiFID II, LGPS funds will be classified as "retail clients" as opposed to "professional clients". If the LGPS funds retain the retail client classification, they will be restricted in the investment managers they can use and the investments they can make. This is because there are fewer investment managers who are permitted to deal with retail clients and certain investments are not deemed suitable for retail clients.

What can the LGPS funds do?

LGPS funds will have the opportunity to elect to be treated as professional clients which will open up the pool of investment managers and investments in which they will be able to invest.

What is the process for electing to be a professional investor?

The current process has two criteria (qualitative and quantitative requirements) which the LGPS fund would need to demonstrate to each investment manager:

• to meet the qualitative criteria, the investment manager will need to be confident that the LGPS fund has the necessary "… expertise, experience and knowledge such that the LGPS fund is capable of making its own investment decisions and understanding the risks involved."
• to meet the quantitative criteria, the LGPS fund will be required to meet two of the following three conditions:

The Financial Conduct Authority (FCA) believes most local authorities and, by implication, most LGPS funds should be able to satisfy the final two limbs (i.e. the size of the investment portfolio and the professional experience of the portfolio managers).

However, the FCA has also voiced concerns that the current "opt-up" test could be too easy for LGPS funds because their business models mean they could easily satisfy the final two limbs of the quantitative test. As a result of this, the FCA may change the "opt-up" process for local authorities in general (which would include their LGPS funds), which could make it harder for LGPS funds to elect for professional client status.

What should LGPS funds do next?

In the first instance, the funds should let their investment committees know about the changes being introduced by MiFID II, which are now due to take effect in January 2018, following the delay to the implementation of MiFID II (previously January 2017).

Lobbying

The Local Government Association (LGA) is in discussions with the FCA to explore whether the election process can be simplified for LGPS funds and is exploring with the FCA and HM Treasury how MiFID II will affect pooling arrangements, specifically how it will affect pooled infrastructure arrangements.

The LGA has written to LGPS funds setting out how MiFID will affect those funds, the timelines and giving more detail about the discussions the LGA is having with the relevant authorities. A copy of the letter can be found here.

Becoming a professional client

Talk to your investment managers – see if they would treat you as a retail client under MiFID II. They may be able to help with your election to become a professional client.
If an election for professional client status needs to be made to each of the fund’s investment managers, a programme for elections should be drawn up to help the fund manage the process.

Collate your quantitative and qualitative evidence for submission in support of your election. In particular, identify who within your organisation will be judged on the qualitative tests and review (and if necessary, change) your delegation processes accordingly.

For more information please contact John Hanratty or Kristy Duane.