Fractional Shares in the EU: CySEC's New Regulatory Framework and Its Implications for MiFID II and analysis of Circular 659 (CySEC)

By Angelina Alyabyeva, Lawyer

Introduction

The financial markets landscape is continually evolving, with technological advancements and innovative investment products reshaping the way investors participate in the stock market. One such innovation that has gained significant traction in recent years is fractional share investing. This phenomenon has prompted regulatory bodies to reassess and clarify the applicability of existing financial regulations to these new investment structures. In response to this trend, the Cyprus Securities and Exchange Commission (CySEC) has issued Circular 659 on the 26th of September, providing crucial guidance on the regulatory treatment of fractional exposure to shares under the Markets in Financial Instruments Directive II (MiFID II) framework.

The Rise of Fractional Share Investing

Fractional share investing has emerged as a popular option for retail investors, particularly in the context of online trading platforms. This approach allows investors to purchase a portion of a share, rather than being limited to whole shares, thereby lowering the barrier to entry for investing in high-priced stocks and enabling more diverse portfolio allocation strategies.

However, the introduction of fractional shares has raised questions about how these investments should be treated under existing regulatory frameworks, particularly MiFID II. The European Securities and Markets Authority (ESMA) took a step towards addressing this issue by issuing a public statement on March 28, 2023, focusing specifically on derivatives on fractions of shares. CySEC's Circular 659 builds upon this foundation, providing more comprehensive guidance on fractional share ownership through trust arrangements.

Scope and Applicability of CySEC's Circular 659

CySEC's circular is primarily aimed at Cyprus Investment Firms (CIFs) that enable their clients to undertake fractional investments in shares issued under the laws of EU Member States and third countries in non-fractional form through trust arrangements. It's important to note that the circular does not apply to fractions of shares created as a result of corporate actions or shares issued in fractional form under corporate laws that permit such issuance.

The guidance provided in Circular 659 is particularly relevant in the context of MiFID II and the Cyprus Investment Services and Activities and Regulated Markets Law (Law 87(I)/2017), which transposes MiFID II into national law. It clarifies that when fractional exposure to shares is achieved through trust arrangements resulting in fractional beneficial ownership, the investment and ancillary services provided by CIFs would qualify as services relating to shares and be subject to the share trading and holding-related obligations laid down in Law 87(I)/2017 and the Markets in Financial Instruments Regulation (MiFIR).

Trust Arrangements for Fractional Beneficial Ownership

A key focus of the circular is the structure and requirements of trust arrangements that facilitate fractional beneficial ownership of shares. Under Cypriot law, such arrangements can be established with a CIF acting as a trustee holding fractions of shares in trust for the client. This creates a fiduciary relationship where the CIF retains legal ownership of the shares, but the clients are the beneficial owners in proportion to their agreed fractional exposure.

CySEC emphasizes that these trust arrangements must comply with the rules governing the holding of financial instruments belonging to clients, as laid out in Law 87(I)/2017 and further detailed in CySEC Directive DI87-01 for the Safeguarding of Financial Instruments and Funds belonging to Clients.

The circular outlines several key requirements for these trust arrangements:

1. Documentation: The trust arrangement must be documented in writing, typically within the agreement between the CIF and the client.
2. Record-keeping: The proportion of beneficial ownership over the shares conferred to the client should be clearly reflected in the CIF's records, serving as evidence of ownership.
3. Rights conferred: All rights emanating from the shares should be proportionately conferred to the clients based on their beneficial entitlement. These rights may include: a) Voting rights b) Dividend distributions c) Residual interest in case of issuer liquidation d) Transferability of whole shares
4. Safeguarding client assets: The arrangements must be constructed in a way that complies with the rules for safeguarding client assets under Law 87(I)/2017 and CySEC Directive DI87-01.

Regulatory Implications

CySEC's guidance has significant regulatory implications for CIFs offering fractional share investments through trust arrangements. The circular clarifies that providing investment services in shares held under such trust arrangements entails the full range of share trading and holding-related obligations laid down in Law 87(I)/2017 and MiFIR.

Some of the key regulatory obligations highlighted in the circular include:

1. Share Trading Obligation: CIFs must comply with the share trading obligation outlined in Article 23 of MiFIR.
2. Systematic Internaliser (SI) Obligations: Where a CIF meets the definition of a Systematic Internaliser under Section 2 of Law 87(I)/2017 and Article 12 of Commission Delegated Regulation 2017/565, it must adhere to the SI-related obligations set out in Title III of MiFIR.
3. Client Asset Safeguarding: CIFs must comply with the obligations relating to safeguarding client assets as laid down in Law 87(I)/2017 and CySEC Directive DI87-01, which transposes Commission Delegated Directive (EU) 2017/593.
4. Information Disclosure: CIFs are required to provide clear, accurate, and non-misleading information to clients and prospective clients about the financial instruments they offer and their services. Importantly, financial instruments enabling investors to undertake fractional exposure in shares under arrangements that do not constitute trust arrangements must not be presented or treated as shares.

Implications for Market Participants

The guidance provided by CySEC has far-reaching implications for various market participants:

1. Cyprus Investment Firms: CIFs offering fractional share investments must ensure their trust arrangements comply with the requirements outlined in the circular. They may need to review and potentially revise their client agreements, record-keeping practices, and operational procedures to ensure compliance.
2. Investors: Retail and professional investors engaging in fractional share investing through CIFs can expect greater transparency and protection. They should be aware of their rights as beneficial owners and the regulatory safeguards in place.
3. Compliance and Legal Professionals: These professionals will need to familiarize themselves with the new guidance to ensure their organizations or clients are adhering to the regulatory requirements when offering or engaging in fractional share investments.
4. Technology Providers: Companies providing trading platforms or other technological solutions for fractional share investing may need to adapt their systems to accommodate the regulatory requirements, particularly in areas such as record-keeping and rights management.

CySEC's Circular 659 represents a significant step in clarifying the regulatory treatment of fractional share ownership under the MiFID II framework. By providing clear guidance on the use of trust arrangements for fractional beneficial ownership, CySEC has addressed a critical gap in the regulatory landscape, ensuring that innovative investment products like fractional shares can be offered within the existing legal framework while maintaining investor protection and market integrity.

The guidance provided by CySEC demonstrates the ongoing challenge faced by regulators in balancing innovation with investor protection. As new investment products and technologies emerge, regulatory bodies must remain agile, providing timely guidance to ensure that the financial markets remain fair, transparent, and accessible to all investors.

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Footnotes:

https://www.cysec.gov.cy/CMSPages/GetFile.aspx?guid=e60dfefe-aacb-4da9-b2f6-7ebbc1e2fd43

https://www.esma.europa.eu/publications-and-data/interactive-single-rulebook/mifid-ii