Liability and enforcement

Territorial scope of regulations

What is the territorial scope of the laws and regulations governing listed, cleared and uncleared equity derivatives transactions?

The various corporate regulatory and listing rules would apply to counterparties regardless of their jurisdiction.

The obligations under EMIR may extend to OTC derivatives contracts even where both counterparties are established outside of the EU - in particular if a contract has ‘a direct, substantial and foreseeable effect’ within the EU or compliance with EMIR is necessary or appropriate to prevent evasion of EMIR. If only one counterparty is inside the EU, in practice the second counterparty would also need to comply with EMIR in order to permit the counterparty inside the EU to meet its own EMIR requirements.

Registration and authorisation requirements

What registration or authorisation requirements apply to market participants that deal or invest in equity derivatives, and what are the implications of registration?

Market participants that engage in the regulated activity of ‘dealing in investments’, including equity derivatives, by way of business in the UK are subject to authorisation by the competent regulator(s) (unless they can rely on an exclusion or exemption). Market participants that are so authorised are subject to the rules and regulations (eg, in relation to conduct of business, standards of market conduct, systems and controls) as are applicable and set out in the relevant rule books (the PRA Rulebook or the FCA Handbook). A rule breach may result in regulatory enforcement action, including fines, public censure and, in extreme cases, withdrawal of the authorisation.

Reporting requirements

What reporting requirements apply to market participants that deal or invest in equity derivatives?

Under MiFID II/MiFIR, market participants executing transactions in certain financial instruments (including, eg, OTC derivatives where only the underlying is traded on a trading venue) are required to report such transactions to the FCA for market surveillance purposes. Market participants may directly report to the FCA or choose to report through an approved reporting mechanism (or through the trading venue where the transaction was completed. MiFID II/MiFIR also extend pre- and post-trade transparency requirements, which will be relevant to market participants in certain scenarios. Waivers and exclusions may be available for example with regard to transactions in instruments for which there is no liquid market or that are large in scale or above the size specific to the financial instrument in question.

In addition to the above, there are general derivatives reporting requirements under EMIR, but these are not specific to equity derivatives.

Legal issues

What legal issues arise in the design and issuance of structured products linked to an unaffiliated third party’s shares or to a basket or index of third-party shares? What additional disclosure and other legal issues arise if the structured product is linked to a proprietary index?

To design and issue structured products (ie, securitised derivatives) that are subsequently sold, an entity may be required to be authorised by the FCA or the PRA. The rules are more onerous if the securities are being offered to the retail market or if they are listed.

If the product manufacturer is involved in marketing the product, then the entity may also need to be authorised under the FSMA. The product manufacturer or distributor, or both may also be subject to the FCA’s MiFID II/MiFIR-derived Product Governance and Conduct of Business rules.

If securities are admitted to trading on a regulated market or offered to the public, then a prospectus may need to be prepared that is compliant with the Prospectus Directive (2003/71/EC). For retail structured products, a product manufacturer will also need to prepare a key information document that is compliant with the Packaged Retail and Insurance-based Investment Products Regulation (Regulation No. 1286/2014), providing details of the structured product in an easy to understand form.

If the structured product is linked to a proprietary index and the product is traded on a trading venue or via a systematic internaliser, the product manufacturer should also pay due regard to the Benchmarks Regulation (Regulation No. 1011/2016) (BMR), which regulates the provision and use of benchmarks, as well as the contribution of input data to benchmarks. In this context, ‘use of a benchmark’ includes issuance of a financial instrument that references an index or a combination of indices, or determination of the amount payable under a financial instrument by referencing an index or a combination of indices. The BMR only applies to financial instruments that are traded on a trading venue (or in respect of which a request for admission has been made) or via a systematic internaliser, as well as certain credit agreements and investment funds.

The FCA’s MiFID II/MiFIR-derived Product Governance rules require manufacturers and distributors to have a proper product approval process in place and, among other things, to:

  • identify with sufficient granularity a target market with the end client in mind;
  • ensure that the product is designed to meet the needs of the identified target market;
  • ensure that the distribution strategy is compatible with the target market; and
  • keep the product under review so that it continues to meet all relevant requirements.

Further, the FCA has conducted thematic reviews of the appropriateness of structured products for investors and is generally interested in this area.

Liability regime

Describe the liability regime related to the issuance of structured products.

There is a range of statutes containing provisions relating to misleading statements made in offering documentation. There may also be additional common law liability. The relevant statutes include the following:

  • The Fraud Act 2006 provides that fraud will be a criminal offence, and this includes dishonestly making a false representation with an intention of making a gain or causing a loss, and dishonestly failing to disclose information where there is a duty to disclose it (with an intention of making a gain or causing a loss).
  • Section 89 of the Financial Services Act 2012 provides that it is a criminal offence to make statements that are false or misleading in a material respect, while section 90 contains prohibitions on giving misleading impressions.
  • The FSMA sets out penalties for failing to comply with the Prospectus Directive, and also details penalties for market abuse (in contravention of MAR) more generally.
Other issues

What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is convertible for shares of the same issuer?

In relation to a new issue of convertible securities, the issuer will need to ensure that it has authority under the Companies Act 2006 to allot the convertible securities. It should also consider whether pre-emption rights need to be disapplied before the issue. Unless an exemption applies, an FCA-approved prospectus will be required if the issue of new convertible securities constitutes an offer to the public; the convertible securities themselves will be admitted to a regulated exchange; or the underlying shares to be issued on conversion will be admitted to a regulated exchange (unless they are of the same class as those already admitted to trading).

In addition, applicable UK listing rules would need to be complied with.

A subscription agreement and a trust deed may also be required in connection with the issue of a convertible security.

In respect of any transfer of convertible securities issued by a UK company, SDRT will generally be payable by the purchaser on acquisition (see question 12).

What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is exchangeable for shares of a third party? Does it matter whether the third party is an affiliate of the issuer?

The considerations applicable to an issue of exchangeable securities are broadly similar to those noted in question 31 in relation to the issue of convertible securities. As the key difference with an exchangeable security is that on settlement the shares to be provided to the counterparty are shares in a third party (and not the issuer of the exchangeable securities itself), if the issuer does not already hold those third-party shares, the counterparty will need to be satisfied that the issuer is able to fulfil its obligation to provide the underlying third party shares on exercise in accordance with the terms of the derivatives contract.

In respect of any transfer of exchangeable securities issued by a UK company or issued by a non-UK company, but exchangeable for shares in a UK company, SDRT will generally be payable by the purchaser on acquisition (see question 12).