The European Commission has continued in its drive towards a European Capital Markets Union by proposing measures in the Prospectus Regulation which it hopes will revamp the current prospectus regime. We are told that prospectuses will become shorter and more user-friendly, yet still provide improved investor protection. In the spirit of this new approach, this paper examines how the proposed regulation attempts to solve the principal issues and asks the question: "In search of simplicity, is the Commission promoting the simplistic?"
The Prospectus Regulation (the "Regulation") published in November 2015 proposed a number of broad-ranging amendments to the prospectus regime currently governed by the Prospectus Directive (2003/71/EC) and its related implementing and amending measures. Market participants will be aware of the various legal commentaries which have set out at length the legal detail in the Regulation. This paper focuses instead on the gulf between the Commission's well-intentioned intervention and the resulting concerns as to issuer liability and investor protection.
Disclosure - the traditional "retail" v "wholesale" distinction
The smaller bond issuer has the choice of approaching sophisticated investors (with deep pockets) in a "wholesale" issue, or the private investor whose investments may be more moderate, in a "retail" issue. Traditionally, the main distinction between the wholesale and retail markets has been defined by the quantum of the smallest potential investment which an investor may make in order to participate in a bond issue.
Retail bonds have, historicaly, typically been issued in units of £100 or £1,000 and, in the UK, are listed on the Order Book for Retail Bonds, or "ORB", a trading facility provided to bonds listed through the United Kingdom Listing Authority on the Main Market of the London Stock Exchange. They are affordable to the man on the Clapham omnibus, and are not intended for institutional investors. Mini-bonds are also denominated in small value units, however they are not listed
Listed bonds always require the issue of a prospectus, but the level of disclosure in a retail issue is greater than in a listed bond prospectus where the denominations are greater than EUR100,000. One unforeseen consequence of this arbitrary threshold has been that smaller issuers which would otherwise have considered issuing a retail bond have been tempted to issue notes in EUR100,000 denominations and above simply in order to reduce the amount of disclosure which would otherwise have been required. As a result, investments which retail investors would otherwise have regarded as attractive have inadvertently been moved beyond their grasp by a quirk of the prospectus disclosure regime. The (albeit unintended) result of narrowing the potential investment pool for the smaller investor is regrettable.
The proposals which appear in the Regulation do away with the EUR100,000 denomination distinction in the hope that secondary market liquidity will increase and portfolio diversification will be improved. The dual standard of disclosure is removed, and a single prospectus template created which will contain an amalgam of the existing wholesale disclosure requirements together with such further information as the Commission deems necessary to protect retail investors. The Regulation sacrifices the availability of lighter disclosure for former wholesale issuers at the expense of a purported increase in the available bond market for retail investors.
Removal of the EUR100,000 minimum denomination prospectus exemption
Under the current regime, if bonds are not listed on a recognised stock exchange and are issued in denominations in excess of EUR100,000, there is no need to issue a prospectus. This is important because if an issuer wishes to keep disclosure to a minimum it may seek to avoid the need for a prospectus altogether.
Patently, the reasoning behind the EUR100,000 minimum denomination prospectus exemption is sound - to obviate the need for a prospectus where investors are in a position to make large investments in the bond markets, are more familiar with the applicable risks and are better placed to weather potential losses.
We must note that exemptions which negate the requirement to issue a prospectus will remain after the Regulation is implemented in the UK, however the red line as to whether they have been met is slightly less stark than the EUR100,000 denomination exemption. The Regulation states that the remaining safe harbours are no longer to be subject to the prospectus regime. Those safe harbours (which are available in respect of bonds which are not listed) include: (a) an offer of securities addressed solely to qualified investors; (b) an offer of securities addressed to fewer than 150 natural or legal persons per member state, other than qualified investors; and (c) an offer of securities addressed to investors who acquire securities for a total consideration of at least EUR 100 000 per investor, for each separate offer. It remains to be seen which safer harbour will be the exemption of choice for the issuer of unlisted bonds.
A single prospectus template
A single format of prospectus for smaller issues is in theory a welcome move which should result in simplified documentation. Such a step is in line with the existing shift in the retail bond space towards the use of plain English in prospectuses. It is generally agreed that it is hard to assess the extent to which true retail investors make their investment decisions based upon the content of prospectuses as opposed to financial advice or marketing initiatives. The imposition of yet another change in the content of offer documents introduces the risk of an unfortunate blurring of the prior distinction between retail and wholesale issues. It would not be surprising if further regulatory guidance and a number of market precedent transactions under the new disclosure regime are required before we will be able fully to gauge how disruptive the proposed changes will be in the eyes of investors.
The Regulation proposes a change to the length of transaction summaries which appear in prospectuses in a move towards the form to be used in Key Information Document from December 2016 by virtue of the packaged retail and insurance-based investment products (PRIIPS) Regulation (EU) No 1286/2014. Base prospectuses will become exempt from the requirement for a summary, which will instead have to appear in the applicable final terms. Stand-alone prospectuses which are not issued in connection with a programme will be required to include the shortened form of summary. The reduction in the length of the summary is welcome insofar as it makes the documentation more digestible, however it is unfortunate that the content of the new form of summary required by the Regulation remains so prescriptive.
The Regulation will require that summaries will be reduced from 15 pages to 6 and will set out (a) key information on the issuer, (b) the security and (c) the offer/ admission of the securities. A summary of 6 pages will in most instances only be achievable by means of a focused consideration of those factors which are most important to investors. This, is of course, the driving impetus behind the changes which are proposed in the Regulation - a shorter, simpler document which is more tailored to the needs of the investors. The underlying regulatory impetus is to avoid the kitchen-sink approach to disclosure, however lawyers are naturally concerned that the need to fall within arbitrary parameters of text may increase the potential liability of issuers by way of an inadvertent but important omission.
Again, the theory behind the Commission's approach is sound, but in practice the degree of responsibility for issuers in ensuring that investors have all of the information which is required to enable them to make an informed investment decision remains unchanged. We have to ask whether that can really be achieved through the production of such truncated summary information. The consumer testing for PRIIPS documentation carried out by the Commission in 2015 found that potential investors favoured diagrams, images and sliding scales to convey risk rather than lengthy text-based explanations. An unsurprising result, perhaps, but a concerning one nonetheless in a capital markets space in which concepts of structuring risk and reward can rapidly become unavoidably complex.
The insertion of risk factors is the agreed method of highlighting problem areas to investors. The mantra often practised in this area is, unfortunately, "more is more" - risk factors can constitute a major chunk of a prospectus. No more. The Prospectus Regulation requires that risk factors be categorised into (a) high-risk, (b) medium risk and (c) low risk, with only the five most material ones being included in the summary. It is acknowledged by the profession that the aim is to reduce the propensity for over-arching and generic risk factors which are designed to cure all ills in a given transaction. The irony here is that, if we assume (perhaps harshly) that an investor were to read only the summary section, surely the most prudent approach would be for the five risk factors appearing in that summary to be the most sweeping and generic of all. Clearly that would not be in the spirit of the Regulation, however if an issuer chooses to protect itself in this way, then the "simple" document being promoted by the Commission may result only in a formulaic approach to a problem which requires a much more nuanced solution.
The Commission has to be commended for proposing a number of measures which are designed to simplify offering documentation, especially for the smaller issuer and the less sophisticated investor. It is entirely appropriate for the Commission to canvas opinion, and we would agree that targeted and cogent disclosure is certainly something to be welcomed. Investors' apparent preference for short documentation containing easily digestible information in picture form is however a predictable response which should not influence the Commission's approach if the result is to render the final content of prospectuses too simplistic and create potential issues as to issuers' liability. It is hard to avoid feeling that the requirement incumbent upon issuers to provide sufficient information for investment purposes is not easily reconcilable with the new regime. The approach proposed in the Regulation pares back the documentation by using arbitrary disclosure parameters which purport to encourage the smaller investor to fulfil an obligation which should be incumbent upon him already - i.e. to review and understand the entirety of a prospectus - no matter how lengthy. We look forward to monitoring how the market receives the proposals in the Regulation, and to how the documentation evolves in its attempt to achieve the melding of these competing forces.
Addendum, 24th June 2016 - The Brexit Referendum
As this article was initially published prior to the UK referendum regarding membership of the European Union on 23rd June 2016, it does not address either the effect of the UK's vote to leave the EU or its impact on the application of relevant European legislation within the UK. However, it should be noted that the referendum result does not itself trigger any legislative changes and accordingly the law as stated in this article remains unchanged at this time. A specific legal process must be followed for a member to leave the EU and the timeline is hardly swift - it is already clear that notice to leave may not be given for many weeks, if not months, and that is just the start of a negotiation process which could take two years or more. Financial services market participants will undoubtedly be monitoring developments carefully as negotiations progress, but until the path forward becomes clearer a period of uncertainty and resultant volatility is inevitable. At least in terms of the EU legislative and regulatory framework for the financial services industry it is business as usual whilst negotiations are in play, and to draw any hard and fast conclusions at this stage as to the post-Brexit landscape would be premature.