On August 2014, Article 3(2) of the EU Regulation on Central Securities Depositories (“CSDR”) was enacted. This provision indirectly mandates change to the London Stock Exchange’s (the “Exchange”) rules in that it requires that all securities on EU trading venues must be recorded in electronic (i.e. book-entry) form in a Central Securities Depository (“CSD”).  The CSDR became effective for securities trading on the LSE earlier this week on September 1, 2015.

Prior to the effective date of the CSDR, Regulation S, Category 3 securities (as defined in Regulation S of the Securities Act of 1933, as amended (the “Securities Act”)) (“Category 3 Securities”) were granted an exception from the Exchange’s Alternative Investment Market (“AIM”) Rule 36 which provides that an issuer’s securities must be eligible for electronic settlement in order to be traded on the Exchange. Category 3 Securities had not previously been eligible for settlement in CREST (“CREST”), the CSD that settles most trades on the Exchange, due to restrictions in connection with U.S. securities laws and related limited settlement procedures. Consequently, issuers applying for admission to AIM have in the past requested an exception from AIM Rule 36 to allow their Category 3 Securities to settle outside of a CSD and in physical, certificated form.

The Exchange and Euroclear UK and Ireland Limited, which owns and operates CREST (“EUI”) developed a set of procedures to facilitate the electronic settlement of Category 3 Securities in compliance with the Securities Act and the CSDR.  On May 11, 2015, EUI published a white book (“White Book”) on its new “Euroclear UK & Ireland: Regulation S Category 3 Settlement Service”. The White Book outlined EUI’s changes to the CREST system in relation to the holding and transfer of Category 3 Securities as well as any eligible resales under Rule 144A of the Securities Act.

In connection with these developments, EUI has released updated CREST forms and the Exchange has published amended rules and various market notices as well as a background note and revised application forms for both the Main Market and AIM.   

REGULATION S, CATEGORY 3 BACKGROUND AND PROCEDURES  

Regulation S provides a safe harbor from the Section 5 registration requirements of the Securities Act for offerings outside the United States by both U.S. and non-U.S. issuers. Because there is the risk that any security that is sold outside of the United States may flow back into the United States, Regulation S sets out restrictions for three categories of transactions, with Category 3 Securities having the most restrictive offering and transactional procedures, including a one year distribution compliance period, due to these securities and related transactions being deemed to have a close nexus with the United States.  

THE NEW ELECTRONIC PROCEDURES  

The procedures developed by the Exchange and EUI are intended to allow for electronic settlement while facilitating compliance with the Category 3 restrictions, and, as such, among other things, require that:

  • issuers (or their registrars, as the case may be) indicate to the Exchange and EUI that: 
    • their securities are subject to Category 3 restrictions (and, if applicable, that such securities are eligible to be resold under Rule 144A) on the relevant admission form; and 
    • the expected date on which the relevant distribution compliance period will end. 
  • issuers notify the Exchange and EUI once the distribution compliance period ends. 
  • each purchaser of securities (or the beneficial owner of such securities) completes electronic purchaser certifications (available via CREST), as summarized below and indicating that:
    • (i) it is not a US person and it is not purchasing the securities for the account or on behalf of a US person; or, to the extent applicable, (ii) it is a US person who is also a QIB and who is purchasing in reliance on Rule 144A or another available exemption from, or transaction not subject to, the Securities Act; 
    • it will resell the securities only in accordance with Regulation S, pursuant to registration under the Securities Act or pursuant to an available exemption from, or in a transaction not subject to, the registration requirements of the Securities Act;
    • it will not to engage in any hedging transactions with regard to the securities except in compliance with the Securities Act; and
    • it is neither the issuer of the Category 3 Securities nor an affiliate of the issuer.

Failing to provide electronic purchaser certifications will result in settlement through CREST being denied, the effect of which is that there is no transfer on the CREST register, which represents the official register of legal title of an issuer’s securities to the extent they are held in CREST in uncertificated form. This has the same effect as a refusal by the issuer to register the transfer of securities.

  • in order to address the Category 3 requirement that legends appear on the Category 3 Securities, the long-form and short-form names used to identify Category 3 Securities on the Exchange trading screens and in CREST will be modified during the distribution compliance period to include the common identifier “─REGS”, and if the issuer has notified the Exchange and EUI that its Category 3 Securities may be offered and sold also under Rule 144A, the common identifier “─S144” will be added in lieu of “─REGS.” Such identifiers are linked to the full text of restrictive legends. 

CONCLUSION  

Category 3 Securities historically experienced very low liquidity in the secondary market compared to securities of comparable issuers trading and settling electronically. In addition, as a result of trading in paper form, settlement of Category 3 Securities generally took between 10 days and two weeks as compared to electronic settlement which generally takes three days. Such low liquidity was believed to be, at least in part, due to the fact that these securities were traded and settled in certificated form resulting in such long settlement periods. The long settlement periods and related poor liquidity is also believed to have negatively affected pricing.

It is expected that now that Category 3 Securities can settle electronically, they will see increased liquidity and present an appealing option for US issuers seeking to raise capital in the London markets.  Issuers are still, of course, responsible for compliance with all US securities laws; while using the CREST system will not automatically establish such compliance, it will allow Category 3 Securities to trade electronically through CREST in accordance with the CSDR while facilitating compliance with the requirements imposed on Category 3 Securities under Regulation S by following the new procedures established by the Exchange and EUI.

For the final version of the Model Document including a comparison between the physical settlement procedures and the new electronic procedures, please click here.