Abstract
This article examines to what extent EU law is effective in preserving global financial stability and, therefore, preventing financial crisis. A difference between macro- and micro-approaches to financial regulation is explained. Whilst the former is concerned with the minimization of systemic risks and maintaining of the financial stability, the latter is focused on the effective regulation of all financial markets’ players, whatever the size of their portfolios. These approaches are the two sides of the same coin, that is limiting the possibility that future financial crises will occur. This paper argues that the effective regulation of investment firms, especially their duty of care, helps to preserve overall financial stability. The choice of the MiFID II as a case study is explained by its appreciation as one of the biggest achievements of EU policymakers in the context of financial law so far. How does a duty to ‘know your customer’ affect global financial stability within the EU? What is the role of soft law in preserving the financial system? These are the questions that this paper seeks to answer.
Keywords
I. Introduction
The paramount objective of EU law is to create a safe legal environment within the EU, whereby the rights and interests of all parties are protected as much as possible. It comes as no surprise, then, that EU law should provide for favourable economic conditions within the EU, which allow for the development of the EU economy and the individual prosperity of its citizens. At the same time, these economic conditions should foster financial stability and security. Therefore, the agenda of EU policymakers should be concerned with an (optimal) balance of promoting entrepreneurship and guaranteeing a safe legal environment.
The 2007/2008 financial crisis has shown that EU law was ill-equipped to prevent and limit global financial disruption. 1 The crisis in the EU originated as a consequence of the US subprime mortgage crisis, but an event that marked its beginning had taken place in the EU: it was a collapse of the Northern Rock Bank, headquartered in the UK. The deposit holders were unable to withdraw their savings, which led to a massive collapse of the EU financial industry.
This paper argues that EU law (both hard and soft law) serves as an appropriate mechanism to prevent future financial crises. Its features, such as harmonization and primacy, allow for the establishment of common rules that apply to all financial markets’ players within the EU. By imposing a minimum standard of conduct, EU law establishes a secure legal framework that guarantees that all those participating in the financial markets execute their activity with due care and skill, in compliance with all applicable legal requirements. This conduct will serve as a safeguard against the occurrence of future financial crises.
The proposed framework for the analysis of EU law as a mechanism against financial crises can be summarized in the following manner. The analysis will firstly discuss the rationale according to which EU law can and should be efficient in this respect, with an emphasis on the harmonization of the obligations of investment firms. Then, the comparison between hard and soft EU law will be presented, so as to evaluate how this symbiosis guarantees a crisis-free, or at least a minimum-crisis, economy. This paper focuses upon the Markets in Financial Instruments Directive 2014 and its Regulation (hereinafter ‘MiFID II’) 2 that regulate individual portfolio management. MiFID II sets up an extensive framework on the obligations of investment firms towards their clients, which has important repercussions on the private law of Member states. Much of the scholarly discussion so far has been focused on the impact of said Directive on the protection of clients under private law, yet MiFID II has not attracted attention with regard to its ability to prevent future financial crises through the lenses of private law. A difference will be drawn between a micro-approach and a macro-approach to preserve financial stability. According to Armour, ‘in contrast to microprudential regulation, which is aimed at safeguarding financial firms, the macroprudential approach focuses on the stability of the financial system as a whole’. 3 Whilst MiFID II is appraised as establishing an effective macro-prudential framework, i.e. combatting systemic risk, the impact of its private law character in the context of preserving financial stability has been somewhat overlooked so far. In other words, this research is not concerned with how well MiFID II counteracts systemic risk, especially in relation to significant financial institutions. Rather, it argues that effective regulation of all investment firms, especially in terms of their harmonized duties of conduct, guarantees financial stability. Both approaches –preventing systemic risk and establishing an effective regulation of markets’ participants – are two sides of the same coin, that is, of a foundation of financial stability.
This paper strives to answer the following questions. How well is EU law equipped to create a safe legal environment within the financial industry? Does MiFID II mainly represent the answer to the problems belonging to the past or does it also have the potential to prevent the new problems from occurring? The financial industry changes on a daily basis, seeking to propose new investment products to investors. Therefore, an additional question this article tackles is whether hard law, which takes a relatively long time to be adopted, should be complemented by soft law, the non-obligatory nature of which entails a simpler and a quicker adoption time, thus making it a suitable instrument to adapt to the needs of an ever-changing financial industry.
This article is structured as follows. It begins by looking at the characteristics of EU law that justify its use as a protection mechanism against financial crises (Part 2). It then proceeds by analysing MiFID II, evaluating its success in the creation of a safe legal environment (Part 3). This article concludes by arguing in favour of the simultaneous use of EU (hard) law and soft law to ensure appropriate financial stability within the EU (Part 4).
2. EU law as a mechanism to prevent financial crises
In order to successfully examine the role of EU law in preventing financial crises, it is important to have a clear picture as to what the terms ‘financial crisis’, ‘systemic risk’ and ‘financial stability’ mean.
A. Defining financial crisis, systemic risk and financial stability
An economic downturn in financial markets generally occurs when the financial markets’ players (banks, insurance companies and investment funds) are not regulated adequately. In other words, a financial crisis takes place when and if the law is not effective in its regulation of market participants. According to Wilson and Grant, global financial crisis can be defined as a collapse of the global financial system. 4 This definition is closely linked to the concept of systemic risk. Systemic risk is ‘a trigger event, such as an economic shock or institutional failure, [that] causes a chain of bad economic consequences (…)’. 5 It follows, then, that financial crisis is synonymous with propagation of systemic risks within the financial system, which cannot be efficiently managed. This ineffectual management is due, first and foremost, to the weak legal tools that national and supranational authorities have at their disposal to intervene timely.
The opposite of a financial crisis is financial stability. Schinasi defines this concept in the following manner: Financial Stability is a situation in which the financial system is capable of satisfactorily performing its three key functions simultaneously. First, the financial system is efficiently and smoothly facilitating the intertemporal allocation of resources from savers to investors and the allocation of economic resources generally. Second, forward-looking financial risks are being assessed and priced reasonably accurately and are being relatively well-managed. Third, the financial system is in such condition that it can comfortably if not smoothly absorb financial and real economic surprises and shocks.
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Veil argues that financial stability has become a primary concern for EU policymakers after the 2007/2008 financial crisis. 7
Therefore, it is possible to state that appropriate financial stability guarantees a crisis-free economy, or at least, the limitation of the damage that a potential crisis may cause. This paper suggests that, whilst financial stability is a macro-concept, thus, the measures trying to achieve it belong to macro-policy, the place that a micro-approach has in promoting financial stability should not be overlooked. Whilst a macro-approach is concerned with preventing the spread of systemic risks generated by significantly important institutions, a micro-approach looks at the conduct of all financial markets’ players, whatever the size of their portfolios. By ensuring that each investment firm exercises due care and skill, that it is acting according to all applicable legal requirements, EU law strives to offer a secure legal environment to all participants.
1. Examples of why inadequate regulation leads to financial disasters
Let us consider the example of the Lehman Brothers insolvency, a legal affair that occurred in Luxembourg and impacted other Member States. The managers of French investment funds contracted with two depositaries, Société Générale and RBC Dexia, to act as custodians for the assets of these funds. This contractual arrangement provided for a possibility to designate a sub-custodian. The Luxembourg branch of Lehman Brothers International Europe (hereinafter ‘LBIE’) acted as a sub-custodian to safeguard the assets of these investment funds. 8 On its collapse, certainly due to the financial crisis, LBIE did not return the deposited assets. At that time, Luxembourg law did not require a depositary to segregate the assets of its clients from its own assets. As such, the creditors of LBIE were allowed to bring claims on all the assets that it held as a custodian, leaving no capital to be returned to the investors of the funds that used LBIE as a custodian. Had Luxembourg law established strict liability of a depositary to segregate and return the assets of its clients, as was the case under French law, the economic downturn might have been minimized.
Another interesting example is the case of Madoff’s pyramid, which originated in the US and the negative economic effects of which quickly spread across the globe. 9 Bernard Madoff was a stockbroker that decided to create his own fund– Bernard Madoff Investment Securities (hereinafter ‘BMIS’) - in the order to invest capital contributions of investors in various hedge funds. He promised a constant return to his clients. When the fund did not realize the promised gains, Bernard Madoff kept on paying out the returns, guaranteed initially, from the capital contributions of new investors. When existing investors wanted to withdraw their capital, there was not enough money to satisfy all redemption requests. BMIS went bankrupt and Madoff was sentenced to life-long imprisonment for financial crime. Had US law been more rigid as to investment ratios and strict supervision by a national regulatory authority, this financial disaster would not have occurred.
These cases are just the tip of the iceberg of what can happen in financial markets without proper regulation. We argue that in this context the systemic risk represents the main problem that should be dealt with by an appropriate hard law. The hard law here refers to the provisions of the different instruments of EU law, such as Directives and Regulations, and their subsequent transposition/implementation in the national law of EU Member States (this concerns the Directives). The guiding principle of these instruments of hard (EU) law is based on the Article 3(1) of the Treaty on European Union, which reads as following: ‘The Union’s aim is to promote peace, its values and the well-being of its people’. 10 Thus, all measures should be taken to guard against possible triggers of undermining this aim.
2. Systemic risk as the main danger of the financial activity
This paper has already defined systemic risk, however, this sub-section will examine this concept in more detail.
Due to the scale of their operations and the cross-border character of their activity, the majority of financial services providers are interconnected. A single financial operation often requires numerous counterparties to act simultaneously. Banks serve as finance providers, insurers give indemnities against possible indebtedness of the creditors, underwrites and brokers act as providers of liquidity in the market. Last but not least, investment funds often provide an additional source of financing and help with re-investing the proceeds of the deal back into the financial markets.
It is not surprising, then, that if one counterparty fails, this may lead to the collapse of a whole financial system. This is often referred to as ‘systemic risk’, that is, a possible negative impact that the default of one financial market player may have on its counterparties, which may endanger the overall financial system. 11 This chain of counterparties can be represented as a circle whereby the default of one ‘ring’ often leads to the destruction of the whole structure.
Systemic risk encompasses two components: (1) credit channel risk; and (2) market channel risk. Each of these categories will be studied separately below.
Credit channel risk refers to the detrimental effect that the failure of a financial service provider may have on its creditors and other counterparties. According to Bodellini, this type of risk is ‘inversely correlated with credit availability’. 12 When financial institutions issue fewer credits, mainly due to lending difficulties, they send markets a ‘bad’ message. Financing becomes scarce and expensive, which leads to a perception that banks are in a near-default state. Deposit-holders may react by immediately withdrawing their money, which causes a ‘run on the bank’, as evidenced by the default of Northern Rock in 2007. This may have a domino effect, where many banks are questioned as to their stability, thus scaring numerous deposit-holders into claiming their money back. This may negatively impact the banks’ counterparties, leading to the overall collapse of the financial system.
Market channel risk concerns the possibility that the failure of one financial institution may generate adverse market movements leading to a withdrawal of credit and investor redemptions. As a consequence, other financial intermediaries trading in the market will have to exit their positions at fire-sale prices, thus causing a vicious circle in forced sales, which in turn can lead to a global financial crisis. 13 Put differently, because of the interconnectedness of financial markets and their participants, a downturn in one market may affect all other markets and trigger the vicious circle by leading all markets to an illiquid state and generating a collapse of the overall financial system.
The last financial crisis made it evident that financial disruption occurs if financial markets’ players are not regulated adequately. This allows them to engage in opportunistic behaviour, which may lead to turmoil in the national and often global financial system. Therefore, it is of utmost importance to assess whether EU law may serve as an appropriate mechanism to prevent or, at least, limit the development of financial crises. This paper argues that a difference should be made between a micro- and a macro-approach to financial regulation. A macro-approach is concerned with limiting the systemic risk that is inherent in the activity of investment firms, especially those that are particularly large. This type of regulation should rely on the combination of law & finance methodology so as to impose a set of obligations on the financial markets’ players. Examples of such regulation include the restrictions on high-frequency and algorithmic trading. A micro-approach is aimed at regulating the conduct of all investment firms with regards to their obligations vis-à-vis clients. Such obligations include a duty of care, that is, the investment firms must act with all due care and skill in fulfilling their professional obligations. We argue that the impact of a micro-approach on the preservation of financial stability is (wrongfully) overlooked in academic literature. As such, it warrants further examination.
B. EU Law as a mechanism to prevent financial disruption
In order to prevent further financial disruption and preserve financial stability within the EU, a set of legislative measures came into force from 2010 onwards. They include a number of Directives and Regulations. Their objective is to create a single rulebook for all financial services providers within the EU.
1. EU single rulebook
This single rulebook is based on three pillars: (i) creation of a single market for financial services; (ii) protection of investors; and (iii) prevention of further financial disruption. The last pillar includes the establishment of national and supranational supervisory bodies to ensure that all market players are properly regulated, supervised and sanctioned in case of a breach of their duties. Examples of such supranational bodies include the European Securities and Markets Authority (hereinafter ‘ESMA’) and the European Central Bank (hereinafter ‘ECB’). ESMA is responsible for preparing technical standards for investment services providers and acts as a watchdog of the EU investment industry. The ECB is allowed to directly sanction the banks located within the Eurozone. 14
Therefore, in the post-crisis period, the goal of EU law as an instrument for preventing financial disruption has been to achieve a single European market for capital and financial services, to ensure the efficiency of capital markets and the protection of investors.
2. Characteristics of EU Law that empower it to serve as a mechanism against financial crises
In order to achieve the establishment of a single European market, EU law is based on a set of principles that include, inter alia, the primacy of the EU law, legal certainty, proportionality, full effectiveness and effective judicial protection. 15 These principles are used to determine the spirit of national legislation, which either transposes or supplements corresponding EU law. In addition, any national legal act that diverges from the provisions of EU law may be set aside or disregarded by the courts, since it undermines the spirit of Community law.
The principle of primacy of EU law has been set forth in Costa v. ENEL. 16 It implies that all EU law instruments (whether a Treaty, a Directive or a Regulation, amongst others) have absolute and unconditional precedence over national law. As such, any conflicting national law provisions should be set aside. Therefore, the strength of using EU law as a mechanism to prevent future financial disruption lies in its primacy vis-à-vis national legislation. By providing safeguards against the opportunistic behaviour of financial markets’ players at EU level, EU law will ensure that the same conduct of behaviour is required from financial services providers in all EU Member States.
Before the 2007/2008 crisis, directives were the preferred legal instrument of EU law. They are binding as to the results to be achieved but leave the choice to national lawmakers on how to achieve these results. The main weaknesses revealed by the financial crisis were regulatory deficiencies and the differences across the Member States’ national supervisory authorities’ investigative and sanctioning powers. As such, there was a transition from directives to regulations, which are directly binding and, therefore, more appropriate for the creation of a single rulebook within the EU. As the example of MiFID II shows, the concurrent use of directives (MiFID II) and regulations (MiFIR) 17 seems to be the preferred mechanism to achieve financial stability within the EU.
It is important to keep in mind that no legal provision is effective unless there is some sanction attached to its breach. Prior to the financial crisis, the EU financial services legislation left the national systems of sanctions largely intact, by requiring only that the remedies be effective, proportionate and dissuasive. However, in the recent legislative initiatives, the EU legislator has relied on Article 83(2) of the Treaty of the Functioning of the European Union 18 (hereinafter ‘TFEU’) to impose criminal sanctions in the areas harmonized by EU legislation. 19 By way of illustration, MiFID II and Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms [OJ L 176/338] impose broadly similar sanctions for the breach of their provisions. The sanctions under the mentioned Directives can be summarized as follows: (i) public censure; (ii) issuance of ceasing orders; (iii) fines up to 10% of turnover for legal persons and up to 5 million EUR for natural persons; (iv) revocation of the firm’s authorization, banning of individuals from holding a managerial or other similar position. These Directives also provide a non-exhaustive list of seven criteria for the determination of applicable sanctions.
To conclude, EU Law can serve as an effective mechanism to prevent financial disruption. This is conditional upon the use of Regulations instead of Directives. In this way, the establishment of a comparable legal environment across all EU Member States can be achieved. Such an approach will allow for the creation of a single level playing field across the EU, whereby all financial markets’ players are submitted to a comparable set of duties and obligations. The primacy of EU law ensures that it has precedence over any national law and contractual provisions. This means that financial disasters such as Madoff’s pyramid and the Lehman Brothers’ insolvency should not occur again. Yet, EU law in financial markets seems to not be sufficient in adapting quickly enough to ever-changing economic conditions. Let us keep in mind that investment business operates on the premise of proposing the most cutting-edge products. This will justify the high fees requested by investment firms because such investment products satisfy the appetite of investors. As financial markets change on a daily basis, so should the regulation of their activity. This will ensure an appropriate level of financial stability and security for all market participants.
After having provided the general analysis of EU law as a mechanism for preventing financial disruption, the following section will assess the success of MiFID II in this respect. MiFID II is vastly appraised as creating important safeguards for clients within the ambit of private law. 20 It is thus interesting to assess whether this Directive achieves its purpose of creating legal stability within the EU within financial markets and, as a result, prevents or limits the occurrence of further financial crises.
3. MiFID 2014: towards better regulation of private law duties of investment firms?
MiFID II represents a major overhaul of its earlier version - MiFID I of 2004. Recital (4) of said Directive states: The financial crisis has exposed weaknesses in the functioning and in the transparency of financial markets. The evolution of financial markets has exposed the need to strengthen the framework for the regulation of markets (…) to increase transparency, better protect investors, reinforce confidence, address unregulated areas, and ensure that supervisors are granted adequate powers to fulfil their tasks.
This article will, therefore, examine the provisions that directly address these aspirations throughout MiFID II.
A. Overview of the key provisions of the MiFID II
This Directive regulates the activity of financial investment providers (investment firms) within the scope of individual portfolio management. An ‘investment firm’ is defined as ‘any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis’. 21
The main themes of MiFID II include: i) authorization and operating requirements of investment firms; ii) authorization conditions for regulated markets; iii) product governance; iv) regulation of commodity derivatives and trading of shares; v) regulatory reporting to prevent market abuse and vi) strengthening of ESMA’s supervisory powers. These measures are tailored to make financial markets more transparent, responsible and investor-friendly.
This paper studies the first theme, that is, the obligations of investment firms, through the lens of their impact on protecting clients and preserving financial stability within the EU. 22 The analysis conducted is therefore selective, as the main focus of research is on the ‘know your customer’ obligation of an investment firm within the ambit of the duty of care. As previously stated, the micro-approach, that is, the effective regulation of all investment firms, creates a safe legal environment wherein a financial crisis is unlikely to occur. The imposition of authorization and operating obligations on the firms ensures that they conduct their professional activity with due care and skill, taking into account all applicable legal requirements. This promotes their compliance, inter alia, with the conditions aimed at reducing systemic risk, such as product governance, anti-market abuse and concentration of trading positions.
This research aims at assessing a very particular component of the ‘conduct of business’ rules for investment firms – the obligation to ‘know your customer’. It will be shown how, by taking into account the interests and needs of a client, the activity of an investment firm will be inherently ‘systemic-risk free’.
B. ‘Know your customer’
In individual asset management, an investment firm has a direct contractual relationship with its client. The duties of the firm consist of providing investment advice and guidance, as well as making investments on behalf of the client. MiFID II establishes a duty to ‘know your customer’ for every investment firm. This requires investment firms to assess the knowledge of investment products and the risk-taking profile of its client before proposing suitable investments to him/her. Article 25(2) of MiFID II formulates this obligation in the following manner: (…) the investment firm shall obtain the necessary information regarding the client’s or potential client’s knowledge and experience in the investment field relevant to the specific type of product or service, that person’s financial situation including his ability to bear losses, and his investment objectives including his risk tolerance so as to enable the investment firm to recommend to the client or potential client the investment services and financial instruments that are suitable for him and, in particular, are in accordance with his risk tolerance and ability to bear losses.
It becomes clear, after reading the definition above, that an important part of the ‘know your customer’ obligation is a duty of care, whereby an investment firm must exercise all reasonable duty and skill in fulfilling its tasks within the ambit of ‘know your customer’. Reverting back to the principle of primacy of EU law, as applied to MiFID II, it means that this duty has prevalence over any national law contradicting provisions or contractual arrangements between the parties.
In its Guidelines on certain aspects of the MiFID II suitability requirements, 23 the European Securities and Markets Authority defines the conditions under which the duty to ‘know your customer’ is deemed to be fulfilled properly. It states, in paragraph 19, that ‘any disclaimers (…) aimed at limiting the firm’s responsibility for the suitability assessment would not in any way impact the characterization of the services provided to clients nor the assessment of the firm’s compliance to the corresponding requirements’. Therefore, it highlights the obligatory nature of EU law.
How does an obligation to ‘know your customer’ guards against systemic risk and financial instability? By taking into consideration the interests and needs of a client, an investment firm must propose him/her suitable and adequate investment products. An investment firm should always act with due care and skill in fulfilling its duties, thereby complying with all relevant legal requirements and keeping the interests of its clients as a priority. This implies, inter alia, not resorting to market abuse or high-frequency trading that is not within the scope of the rules of MiFID II. Such standard of behaviour, if complied with by every investment firm, whatever the size of its portfolio, will prevent the occurrence of systemic risk, financial instability and financial crises. In other words, as long as an investment firm complies with all relevant legal requirements under the ambit of acting with due care and skill, this will guard against an “unhealthy” concentration of risky assets and credits, as well as other malpractices that may lead to the negative financial consequences.
C. Private law effect of MiFID II?
MIFID II is a regulatory law. This means that it creates a regulatory framework for investment services, imposing a set of duties that are potentially sanctioned by a national regulatory authority. Setten and Busch argue that regulatory law is a branch of public law and, as a result, is not a priori concerned with private law regulation. 24 However, by introducing a duty of care of investment firms, MiFID II also has a direct impact on the private law of Member States. Put slightly differently, the duty of inquiring into the knowledge of the client and subsequently proposing him a suitable investment product has now become a mandatory part of any contract of services within individual asset management.
This comes as a big achievement of MiFID II. Member States’ national laws have widely diverging approaches as to who can sue an investment firm and on which basis. Countries such as France and Luxembourg allow potentially any claimant to sue a wrongdoer if the former can prove that he/she has suffered a direct and personal loss because of the latter’s misconduct. This is based on the doctrine of French and Luxembourgish tort law, which perceives legal rules as being created for the benefit of everyone. Therefore, any claimant has a right to sue a wrongdoer for the breach of these legal rules.
In contrast, countries such as the UK strictly limit the group of potential claimants for the breach of regulatory law rules. The Financial Services and Markets Act 2000 (hereinafter ‘FSMA 2000’), as amended, represents the main statute in the area of financial services. Section 138D of FSMA 2000 only allows ‘private persons’ to sue an investment firm for the breach of regulatory law rules. This category of claimants includes individuals and legal persons that do not invest as a way of doing business. Such restriction prevents, therefore, professional investors, such as investment funds and pension funds, to sue an investment firm.
The duty of care as established by MiFID II represents a provision of regulatory law. Yet, since said Directive is an instrument of EU law, it benefits from a primacy over national law provisions, as well as a principle of effectiveness and utility. The latter implies that Member States should facilitate the process of judicial enforcement of the rights stemming from EU law. This consists of, inter alia, ensuring that the procedural law rules for bringing claims based upon EU law and national law are similar. Therefore, the claims arising under the implemented provisions of MiFID II should have the same procedural basis as those stemming from the provisions of national law. In addition, effet utile should provide for such protection of clients under national law that is required by the Directive.
In addition, a duty of care as established by MiFID forms now a part of national contract and tort law. The parties cannot contractually exclude this obligation, because the primacy of EU law entails its precedence over the principle of contractual freedom. Further, the parties can now sue an investment firm both under the specific tort of the breach of statutory law rules and under a general tort. This is because an investment firm owes a duty of care to its clients on a general basis. This includes situations in which, because of onerous evaluation, the investment product offered was not suitable to the client and the latter decided not to subscribe to the contract. Yet, had the client been assessed correctly, he/she might have been offered an adequate product, which means that he/she could have potentially made a profit on his capital. It should be noted, though, that the amount of damages awarded in such cases would be rather trivial, due to the unwillingness of national courts to allow claims for pure economic loss. This position is comprehensible since it seeks to avoid that all clients unsatisfied with the outcome of their investment bring a claim against their investment firms.
However, the decision of the French Court of Cassation in 2018 casts some doubt onto the harmonization of the ‘know your customer’ duties of investment firms within the EU. The case concerned a mother and her daughter who had concluded a contract with an investment firm in 1999 in order to invest their capital in ‘dynamic investment products’. After the death of the mother, the daughter decided to terminate the investment contract and claimed damages in the amount of 250,000 EUR from the investment firm. The claim was based on the allegation that the investment firm did not properly assess the clients’ knowledge and their risk-taking profile. However, the Court of Appeal rejected this claim on the grounds that, despite an onerous suitability assessment, the products offered were nevertheless suitable for these investors. Riasetto affirms that, in the view of French justice, it is irrelevant whether a firm has complied with the obligation to assess the client, what matters is the final outcome, that is, the offer of a suitable investment product. 25
This decision is based on the French doctrine of tort law. The claimant must prove that he has suffered a breach as a result of the wrongful conduct of the defendant. Yet, this case might have been decided differently by English judges, who willingly accord damages for the breach of regulatory law rules, if such claims are presented by an appropriate group of claimants. The position of French courts is open to criticism because closing an eye on a negligent fulfillment of the ‘know your customer’ rules may lead to opportunistic behaviour of investment firms in the future. Referring back to the beginning of this paper, where we explained the legal conditions in which a financial crisis may arise, it becomes clear that unpunished opportunistic and negligent behaviour of financial markets’ players may become a starting point for financial turmoil. It is suggested in this article that, in the case discussed above, the national regulatory authority – l’Autorité des marchés financiers – should have exercised its prerogative to impose disciplinary sanctions, such as ‘naming and shaming’. This would have acted as a deterrent measure to ensure that investment firms do not engage in providing investment advice without first properly assessing the profile of their clients.
MiFID II has attracted divided opinions about its success in influencing the private law of Member States. Busch argues that it directly affects the duty of care of investment firms under private law, thus allowing clients to sue an investment firm both in contract and in tort. 26 In contrast, Malek QC and Bousfield, 27 as well as Wallinca, 28 suggest that the rules contained in MiFID II do not drastically change the private law liabilities of investment firms.
Whatever the impact of MiFID II may be on the private law liabilities of investment firms, what is important, at least for the purposes of this paper, is to know how well it responds to the needs of the changing financial environment. In other words, MiFID II should be assessed through the lens of the public (regulatory) law rules, which have a deterrent effect and which alert both EU and national legislators that a new financial crisis might have just begun. This leads us to the importance of the relationship between private law enforcement and the prevention of financial crises.
A financial crisis rarely starts as a single event. Rather, it is an accumulation of all systemic risks to the point where they can no longer be managed effectively. If an investment firm does not properly fulfill its obligations, that is, proposing suitable and adequate products to its clients, the latter should be given an opportunity to sue the former. Private law enforcement of the ‘know your customer’ goes hand in hand with the regulatory law sanctions imposed by a national regulatory authority. This guarantees the prevention of investment firms’ bad practices that may give rise to systemic risk. Put slightly differently, every investment firm carries a duty of care towards its clients and a national regulatory authority. It is not possible for this financial market player to be deemed to act with due care and skill if it breaches, for example, minimum capital requirements or engages in behaviour that constitutes market abuse. This article has focused only on one component of the duty of care, that is, the ‘know your customer’ obligation, yet the other components are just as important for the prevention of financial crises. Very often, the conduct of an investment firm attracts the interest of a national regulatory authority because of the complaints of the investors. If investors are given sufficient mechanisms to protect their interests via private enforcement and a national regulatory authority intervenes in parallel to impose administrative sanctions, a secure financial environment can be guaranteed.
To conclude, if every investment firm behaves with due care and skill, there will be fewer breaches of EU law (as transposed or applied in every EU Member State) and, as a result, the situations in which financial stability is put into question will be greatly reduced.
D. The regime of sanctions for the breaches of MiFID II
It was mentioned earlier that MiFID II imposes a harmonized set of duties on investment firms, the most important being the obligation to ‘know your customer’. No duty is effective if there is no sanction attached for its breach. The transposition of the EU Directive includes not only modifying the national substantive law but also creating the procedural conditions for its enforcement. Article 70 MiFID II provides that ‘Member States should lay down rules on penalties applicable to infringements of this Directive and ensure that they are implemented’. These penalties should be ‘effective, proportionate and dissuasive’. 29 The references to ‘effectiveness’ refer back to the effet utile of EU law. Effective penalties should ensure that the utility of EU law is preserved, that is, the maintenance of financial stability by protecting the interests of financial market players. This bottom-up approach ensures that the adequate regulation of each market participant results in global stability. Thus, an effective sanction allows to correct wrongful conduct and to bring back the financial system to its safe equilibrium.
The principle of proportionality is a recurrent theme in the EU’s regulation of financial markets. Since most EU directives set forth the legal framework for a particular industry, they cannot anticipate all the details applicable to particular situations. For example, the requirement of a hierarchical separation of the different departments of an investment firm – a safeguard against conflicts of interests – should apply proportionally, that is, reasonably, to entities in light of their characteristics . For example, while it is reasonable to require this separation in a large firm with more than 100 full-time employees, it would be a disproportionate burden to require such a separation for a small firm with fewer than 10 employees, as this would only add to its costs, without effectively changing much in the actual anti-conflict policy.
The proportionality of sanctions thus refers to their reasonableness vis-à-vis a breach committed. MiFID II lists non-exhaustive criteria that should be taken into account by national regulatory authorities in order to decide what penalty to apply to a given case.
In addition, following the reasoning of the European Court of Justice in Von Colson, the penalties should ensure effective judicial protection and have a deterrent effect. 30 In capital markets law, the publication of official decisions of a national regulatory authority has a deterrent effect on all market players.
Following this brief analysis of MiFID II, it is possible to conclude that it strives to prevent the occurrence of financial crises by regulating the activity of investment firms. The extended duty of care is a core obligation of these firms, a safeguard against negligent behaviour. The duty of care implies inquiring into the knowledge and risk-taking profile of a client in order to propose suitable investment products to him/her. In addition, this also includes an obligation of the firm to comply with all relevant legal rules while conducting the activity of providing investment advice. If every investment firm established in the EU adheres to this obligation, the number of breaches of MiFID II will be reduced, leading, in turn, to an increased level of overall financial stability. Therefore, the main argument advanced in this article is that successful financial regulation should not only look at the ‘macro-level’, that is, the attempt to establish a single rulebook and single supervision, but should, first and foremost, focus on the conduct of individual entities. While the creation of a single rule book can only be praised, it does not provide a sufficiently narrow focus for individual cases. These cases refer to new investment techniques and products that appear on a daily basis. It is suggested that EU regulatory law should be supported by soft law, whose flexible and non-mandatory character allows it to fill the gaps of MiFID II.
In summary, MiFID II responds well to the problems occurred in the past and is largely successful in creating a safe legal environment within the industry of individual portfolio management. However, in order for it to be successful in the future, by trying to predict the problems that may arise in the industry and reacting quickly, it should be supplemented by soft law. This argument will be explained in the following section.
4. Preventing financial crises via soft law
Binding legal rules of mandatory nature are referred to as hard law. Some examples include the provisions of MiFID II, as well as the French Monetary and Financial Code and the General Regulations of the Autorité des marchés financiers, which transpose the provisions of the above-mentioned directive into the national law. The parties must comply with these legal rules (hard law) unless the law directly states otherwise.
This should be contrasted with soft law, the rules of which are not legally binding. 31 Some examples of the instruments of soft law include the opinions of international organizations and regulatory authorities, 32 as well as instruments of self-regulation by industry participants.
According to Guzman and Meyer, soft law can be defined as ‘those nonbinding rules or instruments that interpret or inform our understanding of binding rules or instruments or represent promises that in turn create expectations about future conduct’. 33 A most prominent example consists of the legal opinions of ESMA, which are not binding per se but have a persuasive character. Compliance with the principles listed in these documents is expected from the industry participants. These guiding principles supplement or explain hard law, which, in the context of this paper, is represented by MiFID II. Whilst the use of a Lamfalussy framework may provide for a certain clarification of the views of EU legislator, these level II measures still take a long time to be adopted as compared to soft law.
An example of soft law applicable to investment firms is the ESMA Opinion on MiFID practices for firms selling complex products. 34 These guidelines apply to new complex investment products, such as derivatives and financial products that are based on nonstandard indices. ESMA’s aspiration is to bring more certainty and security to potential investors in these products via an enhanced duty to ‘know your customer’. These suggestions, even though not binding, are expected to be taken into account by national authorities on a ‘comply or explain’ basis. In other words, those jurisdictions that do not wish to clarify their national law with respect to the suggestions of ESMA should explain the reasons for their choice not to do so.
The main advantage of soft law lies within its ability to quickly respond to the changes in the investment industry. Whereas a typical EU directive takes months or even years to come into force, the legal opinions of ESMA can be issued within days. This allows ESMA to react to early signs of opportunistic behaviour of investment firms and adopt the necessary guidelines to limit potentially destabilizing conduct. As the lessons of the last financial crisis have shown, the ability of the regulators to respond quickly to the dangerous activity of financial markets’ players and impose sanctions is vital in preserving financial stability.
Of course, this paper does not propound that the legal opinions of ESMA should be considered as superior in value to the provisions of EU law. However, it is here suggested that ESMA may act as the first point of reaction to potentially destabilizing conduct by investment firms. Nothing prevents EU and national legislators from following the advice of ESMA and enacting relevant legal acts. Yet, because this legislation requires a considerable amount of time to be enacted, the applicable soft law will act as a temporary measure, as somewhat of a parachute that takes the financial system from a dangerous turn towards a more secure environment.
5. Conclusion
This article has analysed the role of EU law in preventing financial disruption. The last financial crisis of 2007/2008 has shown that inadequate regulation of financial markets’ players can lead to a global economic downturn. In order to be effective in preventing future financial disruption, EU law should adhere to the following principles. First, it should create a level playing field across the EU financial industry by submitting all market players to a similar set of requirements. Secondly, it should provide for effective supranational supervision of financial services providers. Thirdly, EU law should be constantly reviewed and amended to suit the fast-evolving financial industry. This is where soft law comes into play by supplementing binding EU law.
This paper has also provided the definitions of concepts such as ‘financial crisis’, ‘systemic risk’ and ‘financial stability’. Their understanding is crucial in order to further evaluate the importance of the micro-approach for the preservation of financial stability. Whilst a macro-approach is concerned with limiting systemic risks and promoting financial stability, a micro-approach focuses on effective regulation of all financial markets’ participants. These two approaches are two faces of the same coin, that is, the measures aimed at preventing and limiting financial crises.
In order to evaluate the role of EU law in preventing financial disruption, this paper has assessed the impact of MiFID II on EU financial markets. It is argued here that the measures introduced so far are efficient at preventing further financial crises. By imposing a duty of care, more precisely a duty to ‘know your customer’, said Directive ensures that investment firms fulfil their activity of selling and advising upon investment products with due care and having regard to the profile of their clients. This guarantees that such investment activity is conducted with due diligence, thus adding to the creation of global financial stability.
In addition, a minimum set of sanctions that national regulatory authorities can take vis-à-vis investment firms in case of a breach of these rules will ensure their compliance with EU law. In other words, the imposition of these sanctions will lead to the rectification of negligent behavior, thus bringing the financial system to its equilibrium. These penalties also provide for a deterrent effect on other markets’ participants. For example, public ‘naming and shaming’ may negatively affect the reputation of the investment firm, thus providing other financial entities with an example of how not to behave so as to preserve their reputation in the eyes of their clients.
Last but not least, this paper also considered effect of MiFID II on the private law of Member States. Since the Directive is a public (regulatory) law, it sets forth the duties and obligations of investment firms towards national regulatory authorities. Yet, it also regulates their conduct vis-à-vis their clients, in particular, it establishes a duty to know your customer. This duality of MiFID II provides it with an enhanced capacity to prevent the occurrence of future financial crises.
In order for EU law to be effective in minimizing the possible economic downturns, it should be supplemented by soft law. The former takes a relatively long time to be enacted, whereas the latter can be adopted within days or weeks. Such a combination of legal rules will provide for a secure legal framework that responds to the needs of a fast-evolving financial industry.