On July 26, 2018, the Financial Conduct Authority (FCA) of the United Kingdom issued a Call for Input1 in relation to the Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation2 and the related PRIIPs Regulatory Technical Standards (RTS)3 which took effect in January 2018.
The PRIIPs legislation requires the production of a standardized key information document (KID) whenever a product within the scope of the PRIIPs legislation is being sold or recommended to retail investors in the European Economic Area (EEA), irrespective of where the manufacturer or distributor of the in-scope product is located or regulated. Therefore, this Call for Input will be of interest to, among others, all manufacturers of PRIIPs and those who advise on or distribute PRIIPs within the EEA. The FCA considers that this will include issuers of securities that are classed as PRIIPs, life insurance companies, discretionary investment management firms, firms providing services in relation to insurance-based investments, fund managers, wealth managers, brokers and other firms that provide advice to retail clients, financial advisers, and firms operating retail distribution platforms.
The Call for Input relates to the scope of the PRIIPs Regulation (Regulation), and, in particular, whether certain products are in or out of scope of the PRIIPs Regulation, and also to the cost and risk disclosure requirements in the PRIIPs legislation. In addition, the FCA also invites input on any other practical experiences that market participants have had with the remaining parts of the PRIIPs legislation.
The FCA requests all interested market participants provide input and any accompanying evidence by September 28, 2018. Thereafter, it aims to publish a feedback statement in early 2019 and use the responses to inform its engagement with the three European Supervisory Authorities, and other national competent authorities in the EEA.
THE SCOPE OF THE PRIIPS REGULATION
Ever since the PRIIPs Regulation was passed in 2014, market participants have struggled with the issue of exactly which products are within the scope of the regulation.
The definition of a PRIIP, as contained in Article 4 of the Regulation, is extremely broad and essentially encompasses:
• any investment where, regardless of the legal form of the investment, the amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or to the performance of one or more assets which are not directly purchased by the retail investor; and
• any insurance product which offers a maturity or surrender value that is wholly or partially exposed, directly or indirectly, to market fluctuations.
Although Article 2 of the Regulation specifies a list of certain products to which the Regulation does not apply, the European Commission has never produced a list, or more specific definition, of products that do fall within the scope of the Regulation. This is despite requests from market participants for further guidance from the European Commission and/or the European Supervisory Authorities on the scope of the Regulation. Guidelines from the European Commission have made clear that it is the manufacturers and distributors of products who are responsible for assessing whether the products are within the scope of the Regulation, and that the assessment must take into account the specific economic features and contractual terms and conditions of each product.
The FCA has gone further and published on its website both a list of products that it considers to be within the scope of the Regulation and a list of those that it considers are not.
The FCA makes it clear that investment funds (whether regulated or not) are subject to the Regulation, as well as structured products and structured deposits, derivatives, some non-pension annuities, and many insurance-based investment products.
Contained on the list of out-of-scope products are deposits (other than structured deposits, as defined in the MiFID II Directive4), debentures, and other debt securities where the amount repayable to the investor is fixed
Despite these two lists, there are many financial instruments and contracts that are not featured on either list which have a status that is regarded as unclear by many market participants. In the Call for Input, the FCA highlights certain corporate bonds, such as those that are callable together with payment of a make-whole amount. Although not highlighted by the FCA, one could add to this category certain bonds with step-up coupons (depending on the circumstances leading to the step-up) and floating rate or fixed/floating rate bonds. For instance, a bond with a coupon linked to an interest rate index, such as LIBOR or a swap rate, appears to fall within the broad PRIIPs definition above, because the amount repayable to the investor is subject to fluctuations from exposure to a reference value. However, a deposit with an interest rate linked to LIBOR does not fall within the definition of a structured deposit (as contained in the MiFID II Directive) and is therefore expressly outside the scope of the PRIIPs Regulation. The only relevant distinction between a LIBOR linked deposit and a LIBOR-linked bond is that one is expressly excluded from the PRIIPs Regulation and one is not. However, there is no logic to this differentiation, given that both are fixed income products and the PRIIPs Regulation expressly considers all investment products “regardless of the legal form of the investment.”
The FCA notes that non-compliance with the PRIIPs legislation can incur penalties and as a result, recent bond market data indicate that there has been a significant decline in firms issuing certain bonds to retail investors in the primary market and in distributors selling certain bonds to retail investors in the secondary market. The FCA also notes industry reports suggesting there is uncertainty as to whether some other products, such as UK real estate investment trusts and certain foreign exchange contracts, are in or outside the scope of the Regulation.
Therefore, the FCA is particularly interested in receiving input from providers, distributors and investors to assess the nature and extent of scope issues such as these and possible impacts on behavior in the markets. In particular, they have asked if there are examples of product types where there is uncertainty as to whether they are in scope and whether the respondents have tried to resolve this uncertainty.
CONTENTS OF A KEY INFORMATION DOCUMENT (KID)
For those manufacturers of PRIIPs that have continued to focus on retail investors in the EEA since January 2018, the FCA invites them to provide evidence of practical challenges they have encountered in calculating information to be disclosed in the KID. The FCA also invites investors to describe their experience using KIDs when making investment decisions.
When calculating and disclosing transaction costs in the KID, firms must include implicit transaction costs in the price of a transaction and the RTS have prescribed methodologies to calculate those costs. The methodologies include:
• an “actual transaction costs” methodology, which the FCA describes as “slippage.” This methodology must be followed where the PRIIP has been operating for at least three years and investing in underlying assets consisting of instruments for which there are frequent trading opportunities and publicly available pricing information (these PRIIPs are typically investment funds);
• an “estimated costs” methodology, which must be followed for PRIIPs investing in underlying assets other than liquid instruments; and
• a “new PRIIPs” methodology, which may be followed where a product has been in operation for less than three years.
The FCA is aware of concerns from firms about the practical application of the slippage methodology – in particular, that some funds are disclosing negative transaction costs
The FCA understands that firms may be experiencing difficulties in calculating transaction costs associated with transactions in over the counter (OTC) instruments, in particular non-standardized OTC derivatives.
As a result, the FCA has asked for input as to whether PRIIPs manufacturers have experienced calculations of transaction costs under the slippage methodology which led to negative, zero, or unexpectedly large transaction costs and, if so has requested examples, together with a full calculation of how the output has been obtained and an explanation of any assumptions.
Depending upon the findings, the FCA has said that it will consider running workshops to support firms in their compliance activities in relation to these requirements, but where the FCA sees non-compliance with the requirements, it will consider appropriate supervisory and enforcement action.
The FCA has also requested input as to the experience of investors with disclosures of transaction costs and whether those disclosures have been helpful to them when making their investment decisions, or whether some costs disclosures have been difficult to understand.
One of the requirements of the KID is disclosure of the risks involved in the PRIIP, including a summary risk indicator (SRI) which needs to be supplemented by a narrative explanation of the indicator and its main limitations, together with a narrative explanation of the risks which are materially relevant to the PRIIP but which are not adequately captured by the SRI.
The FCA is aware that some product providers have concerns that the SRI might in some cases be misleading, either because the risk of the product does not appear to be adequately captured by the SRI or because the product has a significantly different SRI from other economically equivalent products.
Therefore, the FCA has requested comments on the SRI and the extent to which the required components of the risk narratives are able to adequately explain the risks of a product to investors. They also request any examples of products with prescribed methodologies for assessing and presenting risk that lead to a counter-intuitive or potentially misleading SRI.
PRIIPs manufacturers are required to include appropriate performance scenarios in a KID under the headings “Favourable,” “Moderate,” “Unfavourable,” and “Stressed” together with information about the assumptions made to produce them.
The FCA states that it is aware of two specific issues in performance scenarios, which may end up giving a misleading impression to investors. It refers to a statement that it gave in January 20185 stating that where a PRIIPs manufacturer is concerned that its performance scenarios in the KID are too optimistic, and at risk of misleading investors, it may provide explanatory materials to put the calculation in context, and similarly that firms distributing PRIIPs may consider providing additional explanations to their clients when they are concerned that a particular KID may mislead their clients.
The FCA now asks for input as to whether manufacturers and distributors have experienced any practical issues in the calculation and presentation of performance scenarios in a KID, in particular any practical difficulties not fully contemplated in their January 2018 statements. They are also interested in hearing from consumers who are using KIDs and who have encountered any issues with the performance scenarios presented to them.
As a general matter, the FCA is particularly interested in feedback from firms and investors about their overall experience in preparing, providing, or using a KID, such as how the KID is presented, the prominence of information in it, examples of where the mandatory content may cause issues, how the KID is provided in practice, and how the KID and supplementary materials are working for multi-option products.