In recent years, structured products sales have grown in a wide variety of non-U.S. jurisdictions. Many of these include countries in the U.S.’s backyard, such as Central America and South America, while others are more distant.
U.S.-based structured note desks, for both U.S. and non-U.S. issuers, are increasingly involved in the sales of products to investors in these jurisdictions. These U.S. desks often have the most useful institutional infrastructure and knowledge base within a banking organization to handle these offerings. Depending on investor preference and other factors, many of these offerings are effected from an issuer’s Regulation S program, as opposed to a U.S. registered shelf or exempt bank note program.
As an increasing number of U.S. broker-dealers begin to participate in these types of offerings, we have prepared this article, which summarizes a variety of issues for U.S. broker-dealers to consider as they begin to participate in these programs.
Who Exactly Is the Issuer?
Most structured note issuers are part of an international financial institution, which may issue notes in different parts of the world through different entities, including one or more funding vehicles. Some financial institutions may have more than one Regulation S program, and sometimes more than one Regulation S program that provides for the issuance of structured notes. Accordingly, the broker should determine at an early stage which corporate entity is the issuer. The broker will need to confirm that its due diligence procedures are appropriate as to that entity. To the extent the broker is receiving periodic deliverables, such as comfort letters and/or legal opinions, the broker will wish to ensure that it is receiving them for the correct issuer and program.
What Regulation S Requirements Apply?
A full discussion of Regulation S’s requirements is beyond the scope of this article.12 However, we would note that a key question for any Regulation S offering is which Regulation S category the relevant issuer falls into. Of the three categories, “Category 1” imposes the fewest requirements, “Category 3” imposes the most requirements and (surprise) “Category 2” falls between the two. Most structured note programs discussed in this article fit within Category 2 or Category 3.
The relevant category has a number of results, including certain legending requirements in the offering documentation, the form of the notes that must be used to evidence the transaction, and certain substantive provisions that must be included in any agreements with the distributors of the notes. These provisions are found in Rule 903 of Regulation S, and counsel will need to know the correct category in order to properly document the transaction.
Scope of Disclosures
As compared to SEC-registered offerings, the offering documents for Regulation S structured notes have fewer prescribed form requirements. (Of course, for liability purposes, the documents cannot contain any material misstatement or omission of a material fact.)
That being said, a broker may seek to conform the content of the disclosures, and some of the presentation, to that of its registered notes. For example, some investors may purchase (and some distributors may distribute) notes with similar terms from both channels, and may wish to see comparable disclosures, including the relevant risk factors and the presentation of hypothetical examples and/or historic performance information. Making the disclosure comparable can facilitate an investor’s understanding and evaluation of the product. In order to avoid any timing issues, the form and content of the disclosures should be agreed upon as early as possible with the relevant parties.
Stock Exchange Listing
Most EMTN programs are listed on one or more European or other stock exchanges, such as the London Stock Exchange. Where the program is listed on a regulated market in the EU, the issuer must deliver a prospectus in compliance with the European Union’s Prospectus Directive requirements. However, the issuances of structured notes that are offered by U.S. broker-dealers, particularly when they are made on a reverse inquiry basis, are often not independently listed. This is particularly relevant in the case of issuances to European investors, even if issued under a program that is listed on a regulated market in the EU. This is because, unless all principal terms and risk factors relating to the particular structured note issuance and matters requiring inclusion in the prospectus under the Prospectus Directive are already included in the base prospectus, the structured notes are not permitted to be listed unless issued under a new Prospectus Directive-compliant prospectus or unless the existing program is amended, either of which will require approval by the relevant competent authority. This step would be a “speed bump” for any proposed offering.
Accordingly, if there is a plan to list the relevant issuance on a regulated market in the EU, advance planning should be made to ensure the completion of the relevant documentation.
A U.S. broker may be party to a program or similar agreement with an issuer for U.S.-registered structured notes, and may be party to selling group agreements with downstream dealers for sales of those products. However, those existing agreements, whether based on SIFMA model forms or otherwise, will typically not contemplate Regulation S sales.
Accordingly, the relevant entities will wish to make sure that appropriate Regulation S-compliant agreements are in place between the relevant parties to the distribution. The section above, “What Regulation S Requirements Apply?,” which discusses the differences between different categories, is relevant here, as the relevant Regulation S provisions impose different substantive requirements. For example, in Category 2 and Category 3 offerings, distributors selling to other dealers during the so-called “40-day distribution compliance period” must send a confirmation or other notice to the purchaser stating that the purchaser is subject to the same Regulation S restrictions on offers and sales that apply to a distributor.
Determining the End of the Distribution Compliance Period
For debt securities in “Category 2” of Regulation S, such as most structured notes, distributors cannot sell the notes into the U.S. in secondary sales until the end of a 40-day “distribution compliance period.” This period typically begins when the initial offering has been completed. In syndicated offerings, this date can be hard to pin down, as one or more distributors may not have sold their full allocation on the pricing date, and may hold some of the offered securities included in their accounts. However, for structured notes sold in Regulation S offerings, this is typically not an issue. In these types of offerings, the size of the offering is usually expected to match the amount of orders placed. Distributors will need to make one another aware if this is not the case, and if the initial offering has in fact not been completed at the time of the pricing.
FINRA Offering Communication Rules
If a U.S. broker is participating in the offering, attention must be paid to the relevant FINRA rules, including FINRA’s new communication rules, which became effective in February 2013. If any term sheet or other document prepared by a FINRA member constitutes a “retail communication” (distributed to 25 or more “retail investors”), it will be subject to FINRA’s approval, content and retention requirements.13
Bearer vs. Registered Form and TEFRA D
Some Regulation S programs provide for notes issued in bearer form for U.S. federal tax purposes, and some programs provide for notes in “registered form.” Other programs provide for both, and the form will vary from issuance to issuance.
The U.S. Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) imposes certain restrictions on the issuance and ownership of bearer debt securities. TEFRA was designed to promote the issuance of debt securities in the U.S. market in registered form, so that U.S. tax authorities can trace ownership of the securities and determine whether holders of those securities have paid their U.S. taxes on related income and gain. While the TEFRA rules do not explicitly prohibit an issuer from issuing a bearer debt security to a U.S. person or prohibit a U.S. person from holding a bearer debt security, they impose stiff penalties on those issuers and holders. As a result, U.S. and foreign issuers must consider TEFRA implications in offerings of bearer debt made in reliance on Regulation S.
The TEFRA rules provide the following sanctions against any issuer of certain securities in bearer form:
- denial of a deduction for interest payments on these obligations; and
- imposition of an excise tax equal to 1% of the product of the principal amount of the obligation and the number of calendar years (or fraction of a year) during the period from the issue date to maturity.
A U.S. taxpayer holding such a security in bearer form may be subject to the following sanctions:
- denial of a deduction for losses incurred on these obligations; and
- treatment of gains resulting from the sale or exchange of such obligations as ordinary income
In addition, the portfolio interest exemption is not available to shield interest payments with respect to bearer debt obligations from U.S. withholding tax if the obligations are issued in violation of the TEFRA rules. Although in form this sanction appears to be a holder sanction (because the burden of the withholding tax falls on the holder), it may instead impact the issuer if the issuer is subject to an obligation to gross-up the holder for any withholding taxes, or is determined to be liable for taxes it failed to withhold.
Regulations under TEFRA (the “TEFRA C” and “TEFRA D” regulations) identify the kinds of arrangements that are reasonably designed to ensure that bearer securities will be sold (or resold in connection with the original issue) only to a person who is not a U.S. person. These rules operate independently of Regulation S, and compliance with Regulation S will not ensure compliance with TEFRA.
On March 18, 2010, the U.S. Hiring Incentives to Restore Employment Act (the “HIRE Act”) was signed into law. With respect to debt obligations issued after March 18, 2012, the HIRE Act repeals the exemption from the TEFRA sanctions. As a result, any issuer of certain bearer securities will be denied an interest deduction. In addition, interest payments on such obligations will no longer qualify for the portfolio interest exemption, thereby subjecting such interest to a 30% U.S. withholding tax.
The HIRE Act preserves the exception to the excise tax for securities that are issued under TEFRA-compliant procedures. As a result, foreign issuers of a “foreign-to-foreign” bearer debt offering that is TEFRA-compliant would not be subject to the excise tax.
Non-U.S. Selling Restrictions?
Until this point, we have focused on U.S. and European regulations. However, depending upon the countries in which the notes are sold, a variety of additional non-U.S. and non-European legal provisions may apply to the offering. In particular, depending upon the countries in which the notes will be offered, a variety of selling restrictions may be required (or advisable) under applicable law. In some jurisdictions, the relevant private placement regime may not offer as clear a safe harbor as, for example, U.S. Regulation D or U.S. Rule 144A. Accordingly, brokers may wish to obtain advice from local counsel prior to offering in a new jurisdiction.