Rule on Inducements - COBS Provision

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The JC’s Reg and Leg resource™
UK Edition

2.3.1 in a Nutshell™ (COBS edition)

2.3.1 A firm cannot give or take any benefit relating to client business except:

(1) Client Benefits: one the client pays for/receives directly; or
(2) Third Party Benefits: a third party pays/receives if:
(a) No impairment: it does not impair the firm’s duty to act in the client’s best interests; and
(b) Full disclosure: the firm fully discloses it before providing it; and
(c) Service enhancement: it enhances the quality of the firm’s service to the client; or
(3) Ancillary Benefits: one that facilitates designated investment business or ancillary services and doesn’t conflict with the client’s interests (eg custody, clearing or exchange fees, legal fees, etc.)

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This is the FCA’s general Rule on Inducements —and more to the point, avoiding them — and as you’ll see it is cast with an eye to the client’s best interests. Compare with specific rules on use of dealing commissions, which some might say are no more than an articulation of these, but others would say are quite a lot more restrictive, but which relate only to firms which act as investment managers — potentially a key difference, because it would not catch a broker or dealer where it accepts orders from an investment manager who was not an FCA regulated firm (i.e., a foreigner).

To be clear, in this case the general rule on inducements would continue to apply to the broker: just not the more detailed use of dealing commissions rules.

Want to take your client to Wimbledon? Forget about it.

Retrocessions for fund aggregators

If you are a MiFID entity there are these categories:

  • Those providing portfolio management services or independent advice;
  • Those not providing independent advice (basically anyone else)

For the first two there is an outright prohibition on retaining rebates under MiFID II. Everything must be passed in full through to the ultimate client. These entities therefore tend to opt for non-retrocession share classes open only to aggregators offering a certain volume that have a net management fee (so in other words the benefit of the discount naturally flows through to ultimate client and can’t be retained by the intermediary, and there’s no need for the brain damage of divvying up the rebate).

For others it isn’t prohibited but the firm would need to demonstrate (per COBS 2.3A.3 that the payment “enhances the quality of the service” it provides to its our client, and fully disclose it. The level 2 regulations interpret this strictly, and impose more procedural requirements, than many firms currently apply to third party payments and benefits.

A bit like PFOF?

Payment for order flow is the practice of an investment firm that executes client orders (typically a broker) receiving a fee/commission not only as an agent from the client originating the order but also from the counterparty with whom the trade is then executed. PFOF is not allowed because it does not satisfy the rule on inducements.

The read across is instructive: Some (but not all) of the points the FCA highlighted for PFOF prevail here, if you substitute “firm” for “broker” and “MMF provider” for “market maker”

  • It creates a conflict of interest between the firm and its clients because the firm is incentivised to pursue payments from “MMF providers” rather than to act in the best interests of its clients.
  • Forcing MMF providers to ‘pay-to-play’ can distort competition and create barriers to entry and expansion.

See also

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