Newsflash - CSSF Circular 23/840

On the 14 September 2023, the CSSF¹ published the Circular 23/840 to inform financial market participants in Luxembourg that the Guidelines of the European Securities and Markets Authority ("ESMA") on MiFID II² product governance requirements dated 3 August 2023 (the "Guidelines") are applicable in Luxembourg to harmonise the application of the MiFID II requirements on product governance and reinforce investor's protection from the 3 October 2023 onwards.

The Guidelines replace the ESMA Guidelines dated 3 January 2018 on the same topic and bring essential clarifications notably on the following points:

The scope of application: as a reminder, the initial scope concerns investment firms and credit institutions when providing MiFID II investment services and activities including when selling or advising clients in relation to structured deposits, UCITS management companies and external Alternative Investment Fund Managers when providing the investment services of individual portfolio management or non-core services (the "Firms"). These Guidelines extend the scope of applicable requirements with investments firms required to keep records of all activities, services and transactions to facilitate the supervisory tasks of the CSSF under article 16(6) of MiFID II while clarifying that financial instruments exclusively marketed or distributed to eligible counterparties in accordance with the Article 16a exemption under MiFID II fall outside of its scope.

Target market identification:

• "positive" target market: the Firms acting as distributors³ and/or manufacturers⁴ have to identify their "positive" target market and, to this end, specify any sustainability-related objectives that the product is compatible with, including, among others, the minimum proportion of the product that is invested in sustainable investments⁵ and the principal adverse impacts (PAI) on sustainability factors considered by the product etc. The Guidelines also introduce the ability for the distributor to use the product for diversification and hedging purposes and sell them outside the identified "positive" target market when (i) the portfolio as a whole or the combination of a financial instrument with its hedge is suitable for the client  or (ii) the sales occur in relation to the sustainability-related objectives of the product in line with the ESMA Guidelines on certain aspects of the MiFID II suitability requirements (the "Suitability Guidelines"). This deviation is not justified in respect of the "client type" and "clients' knowledge and experience" categories for the purpose of diversification and hedging except, in the case of portfolio management, where the level of "clients experience and knowledge" can apply the approach set out in the Suitability Guidelines.

• "clustering approach": the Guidelines introduce the practice of identifying a target market per cluster of products instead of per individual product for certain complex and risky products. In their assessments, manufacturers and distributors should consider (i) multiple key factors⁶ to set out clear criteria for each product, and, where applicable, (ii) the outcomes of the charging structure and (iii) the scenario analysis of each product.

• assessment conducted by distributors: a distinction is made in the level of granularity for the identification of the target market of manufacturers and distributors respectively, whereby the former identify a potential target market and the latter an actual target market. The distributor will either (i) take into consideration the boundaries of the potential target market set by the manufacturers while implementing a more rigorous client categorisation consistent with its suitability and appropriateness arrangements or (ii) where the manufacturer is not subject to MiFID II product governance requirements, define its target market based on information gathered from the manufacturer.

Distribution strategy: the distributor should take into account the distribution strategy of the manufacturer, where applicable, and establish a strategy based on its client base and services provided. Consequently, the distributor can decide to take a more or less prudent approach when offering investment services which as a result will influence the level of protection afforded to investors. When distributors are unable to make a full target market assessment, clients may be allowed to operate on a non-advised basis subject to receiving a warning that the Firms are not in the position to assess their full compatibility with such complex products. This does not exempt the Firms from the obligation to review the products nor should products be distributed under non-advised sales if the distributor cannot reasonably expect (i.e., ex-ante) that the distribution strategy for the product will generally enable the product to reach the identified target market. Therefore, to ensure its strategy is compatible with the product's target market, in particular, a complex product with a narrow target market, the distributor should also consider the type of marketing strategy for the specific product and the product display in the client's choice environment.

Periodic review of products: the Firms are required to conduct a regular review of their products using both quantitative and qualitative criteria to assess whether these remain aligned with the identified target market and the distribution strategy remain appropriate. These criteria are related to the product's characteristics, market conditions and distribution. The Firms should consider on a proportionate basis what information would be required to complete the review and the means of collecting this information. Distributors should be proactive in providing information that is relevant for the manufacturers' reviews in addition to information on sales. The information can be provided in aggregated form and does not need to be on an instrument-by-instrument or sale-by-sale basis.

The frequency and depth of such reviews is at the discretion of the Firms taking into account the nature of the product and, where appropriate, the service, however, complex products would generally require more frequent and in depth reviews. Distributors are required to review products as long as they are offered, sold or recommended.

Actions to be taken by the Firms concerned: the Firms should conduct regular product reviews and take a granular look at their internal operations, procedures and policies, including marketing and product display, to ensure that these comply with any sustainability-related requirements and clustering criteria of their products in order to remain aligned with the established target market and distribution strategy.

¹ The Commission de Surveillance du Secteur Financier (“CSSF“).
² Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments as amended.
³ Para 2.3 of the Guidelines: “a firm that offers, recommends or sells a product and service to a client”.
⁴ Para 2.3 of the Guidelines: “a firm that manufactures a product, including the creation, development, issuance or design of that product, including when advising corporate issuers on the launch of a new product”.
⁵ Defined in Article 2, point (17), of Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector (OJ L 317, 9.12.2019, p. 1).
⁶ risk factors; charging structure; optionality elements; financial leverage; eligibility to bail-in; subordination clauses; observability of the underlying; guarantees of principal repayment or capital protection clauses; liquidity of the product and the currency denomination of the product.