On 26 November 2015, the European Securities and Markets Authority (“ESMA”) published its Final Report on its “Guidelines on complex debt instruments and structured deposits”. The Final Report follows ESMA’s Consultation Paper on the same issue published in March 2015 on which we previously reported1.
Background and Initial Consultation
The Consultation Paper is focused on the “execution-only exemption” contained within the Markets in Financial Instruments Directive (“MiFID”) and the amendments to such exemption made pursuant to a recast MiFID Directive now expected to come into force from January 2018 (“MiFID II”). This exemption relates to the level of diligence that firms are required to carry out on their clients before providing financial services to such clients. Where an execution-only service relates to non-complex financial instruments specified in Article 19(6) of the existing MiFID and certain other conditions apply, the investment firm can provide the service to the client without having to carry out either suitability or an appropriateness assessment in relation to such client. The Article 19(6) list of instruments includes bonds and similar debt instruments admitted to trading on a regulated market or equivalent third country market but specifically excludes any such bond or other instrument that embeds a derivative.
Article 19(6) of MiFID will be replaced by Article 25(4) of MiFID II when it comes into force. In addition to the exclusion of debt and other instruments embedding derivatives, the exemption will also exclude (i) bonds or other securitised debt incorporating a structure which makes it difficult for the client to understand the risk involved and (ii) structured deposits which incorporate a structure which makes it difficult for the client to understand the risk of return or the cost of exiting the product before its term. ESMA is required under MiFID II to develop technical standards by 3 January 2016 as to how these additional provisions should be assessed.
In its Final Report, ESMA notes that it received 32 responses to the Consultation Paper. Following this feedback, ESMA states that it has made some modifications to the Guidelines set out in the Consultation Paper and provided further analysis in relation to what it regards as an embedded derivative.
A key element of ESMA’s previous Consultation Paper was its non-exhaustive list of debt instruments which it would generally regard as embedding a derivative or incorporating a structure, making it difficult for the client to understand the risk involved and, in each case, therefore not being capable of falling within the execution-only exemption. In the Final Report, these examples have now been moved into a table within the Guidelines themselves.
Instruments Embedding a Derivative
In relation to the examples of instruments that ESMA regards as embedding a derivative, the only change to the previous Consultation Paper is the deletion of inflation-indexed bonds. Following the responses to the Consultation Paper, ESMA acknowledges that such bonds are widely used by retail investors as a hedge against inflation, and the average retail investor normally understands the mechanism involved. ESMA states that it accepts the argument that the link between the coupon or principal payment and the inflation rate should not be regarded as an embedded derivative within the meaning of the guidelines, and such products should not, therefore, be regarded as complex. Convertible/exchangeable bonds, indexed bonds and turbo certificates, contingent convertible bonds, callable/puttable bonds, credit-linked notes and warrants all remain within the list of examples of debt instruments embedding a derivative.
Instruments Incorporating a Structure Making it Difficult for the Client to Understand the Risk
In relation to instruments that incorporate a structure making it difficult for the client to understand the risk, ESMA has deleted the general definition contained in the Consultation Paper stating that this should be interpreted as meaning “a structure and the related risks that an average retail client would be unlikely to readily understand” following feedback in the consultation that this general reference was not helpful in practice. In its list of examples of products that would normally be regarded as coming within this category, very few changes have been made by ESMA, but the following points should be noted:
- The examples now include a specific reference to debt instruments with complex mechanisms to determine or calculate the return. It is stated that this category includes debt instruments structured in such a way that the anticipated revenue stream may vary frequently and/or markedly at different points of time over the duration of the instrument either because certain pre-determined threshold conditions are met or because certain time points are reached.
- ESMA has accepted that the fact a debt instrument is denominated in a non-domestic currency should not automatically make the instrument complex and should not, therefore, be regarded as coming within its categorisation of debt instruments with an unfamiliar or unusual underlying.
- ESMA has deleted the specific reference to instruments that would be regarded as packaged products under the PRIIPs Regulation on the basis that such products will almost certainly be deemed complex under one of the other categorisations.
- In relation to debt instruments issued by SPVs, a slight change has been made to state that this applies in circumstances in which the name of the debt instrument or legal name of the SPV may mislead investors as to the identity of the issuer or guarantor.
In relation to the list of criteria that would result in a structured deposit incorporating a structure making it difficult for the client to understand the risk of return, ESMA has added the situation where the contract gives the credit institution the unilateral right to terminate the agreement before maturity.
Examples of Non-Complex Products
In addition to examples of debt instruments that would generally be regarded as complex, the Consultation Paper also included a list of debt instruments that would be generally regarded as non-complex by reference to the relevant criteria, although this was a short list comprising of step-up notes (providing for an increasing rate of interest over time according to a predefined schedule), floating rate notes and covered bonds. The Final Report includes an additional list of instruments that it would not regard as embedding a derivative or incorporating a structure which makes it difficult to understand the risk, including:
- inflation-linked notes;
- debt instruments denominated in a currency different from the one of the jurisdiction where the investment services are provided; and
- structured deposits where the return is linked to a currency which is not the one of the jurisdiction where the structured deposit is offered.
ESMA also states that it accepts the argument that a tax clause feature (allowing the issuer to redeem an instrument in the case of future changes to tax law that would require it to make additional payments) is relatively simple and should not make an instrument complex for the purpose of the Guidelines.
ESMA now regards the Guidelines as final and states that they will now be translated into the official EU languages and published on ESMA’s website. The publication of the translations will trigger a two-month period during which national competent authorities must notify ESMA whether they comply or intend to comply with the Guidelines.