This week we look at the FCA's announcement to ban certain kinds of clauses in agreements between clients and regulated firms. This relates to clauses included by financial institutions that require clients to use that financial institution for future primary markets and M&A work.
FCA to ban "restrictive contractual clauses"
From 3 January 2018, firms regulated by the Financial Conduct Authority (FCA) will no longer be permitted to include certain "restrictive contractual clauses" in written agreements with their clients.
What is being banned?
The ban will prohibit regulated firms from including "future service restrictions" in written agreements with clients. These are clauses that require a client to use that particular firm in the future in relation to certain kinds of services.
The ban will apply only to primary market and M&A services. These are "designated investment business" or "MiFID business" that relate to structuring, underwriting and/or placing an issue of shares (or certain other instruments) or a merger or the purchase or disposal of an undertaking. In other words, non-transactional services do not appear to be caught by the new prohibition.
Specifically, two kinds of restriction will be banned:
- Right to act clauses. These oblige the client to use the firm in relation to the services in question.
- Right of first refusal clauses. These give the firm the right to provide the services in question to the client before the client can use another provider.
The FCA believes that these kinds of clause stifle competition in the market for services relating to primary markets transactions.
What is not being banned?
To appreciate the extent of the ban, it is necessary to understand what firms will still be allowed to do. The Policy Statement and the new rules give an indication of the limits of the prohibition.
- Products and services to which the agreement relates. The ban will not prevent clauses that require a client to use a firm for services relating to the transaction, as these are not within the definition of "future services restrictions". The FCA has not elaborated on this, but this would presumably permit (for example) a firm acting on a placing to require the client to use it as the broker on the deal.
- "Specified" and "certain" future business. The ban applies only to unspecified and uncertain future business. Unfortunately, the new rules do not define "specified" or "certain". The FCA has declined to provide any further guidance on these terms, stating that "the rationale for the ban is clear" and that further guidance on these terms would not "add value".
- Recouping costs for past services. The ban applies only to future services. The new rules specifically allow clauses requiring a client to pay for past services if it ultimately uses another firm for the work. In other words, firms will continue to be able to include so-called tailgunner clauses.
- Right to match clauses. The ban will not prevent firms from including clauses giving them the right to take part in future pitches or to match quotations from other providers. However, to be permitted, the clause must not oblige the client to use the firm if it successfully matches on price, as this is at odds with the FCA's objective that clients must be free to choose their provider.
- Bridging loans. The FCA recognises that firms are unlikely to provide bridge finance without a guaranteed right to provide the longer-term finance replacing the bridge. Bridging loans are therefore exempted completely from the ban. The FCA has clarified that the exemption extends to so-called warehouse facilities, which normally take the form of short-term revolving credit facilities to allow another financial institution to originate mortgage loans.
The new rules set out three common characteristics of bridge loans. These are where: the parties expressly document that the loan offers a "temporary solution" until the client obtains longer-term financing; the loan has a short term (typically less than four years); and the client is obliged to use future financing to prepay the bridge.
Although a loan may still be exempt if it fails to satisfy one or more of these criteria, firms will want to consider addressing these items to ensure the prohibition does not apply.
- Hedging facilities. The paper also acknowledges the use of hedging facilities and that they serve a similar purpose to bridging loans. Although hedging facilities are not specifically carved out of the new prohibition, it seems that the FCA does not regard them as being caught by the ban.
- Incremental facilities. The FCA has confirmed that the ban will not cover terms in loans allowing borrowers to take out incremental facilities (so-called "accordion provisions"). This seems to be because these facilities do not fall within the definition of primary market and M&A services.
Where will the ban apply?
The ban will apply to firms conducting services from a UK establishment (including through overseas branches), regardless of where the client is based. However, it will not apply to agreements between a client and a non-UK regulated firm.
Certain respondents expressed concerns in the consultation that this might lead to UK firms being less competitive than their overseas counterparts. The FCA has dismissed this on the basis that it was provided with no evidence to underpin this concern and that the risk seemed "overstated".
It is currently quite common for investment banks to include clauses in engagement letters giving them a right to act on or tender for future business. These may well be modified or removed following negotiations between the investment bank and its client. In the future, these clauses will be prohibited from the outset if they restrict the client's ability to shop elsewhere.
In principle, the aim of ban is straightforward. The difficultly will come in deciding whether a given set of services is "unspecified" or "uncertain". It seems clear that certain services will be "specified" or "certain" (such as the right of a placing agent to act as the broker or underwriter on the placing, or the right of the financial adviser on a disposal to act as the placing agent for any vendor consideration shares), and we cannot see how the ban will affect common mechanisms that are integral to placings (such as orderly market arrangements). (These are also likely to be services to which the agreement relates and so acceptable on that basis too).
However, the position may not be so clear where the restriction relates to a category of services (such as "brokerage services"). In this case, although the general nature of the services may be clear, the fact that the description does not refer to a specific transaction might well render it "unspecified".
Regulated firms have six months to prepare before the ban comes into effect on 3 January 2018. The ban will not have retrospective effect, so firms will not need to change the terms of their existing engagements. However, given that these clauses will be banned in due course, regulated firms should expect to receive strong push-back from clients if they include these provisions in proposed engagement letters before the ban comes into force.
To be ready, firms should start reviewing their terms of business now to identify any restrictions that might fall foul of the ban. These restrictions will need to be excised so that they do not form part of agreements entered into from 3 January 2018. Although outside of the scope of the restriction, non-regulated firms might also consider whether, as matter of market practice, it remains appropriate to include clauses of this kind in their engagement letters.
- The City of London Law Society and Law Society have updated their Q&A paper on the EU Market Abuse Regulation ("MAR"). The updated paper contains new responses where parties are negotiating contractual arrangements for a transaction and the arrangements involve a share subscription. (The paper gives the specific examples of an issue of consideration shares in connection with an acquisition, an undertaking to subscribe for shares under a firm placing, and signing an irrevocable undertaking in connection with a takeover.)
- In summary, the Q&A conclude that, although the position must be analysed on a case-by-case basis, an issuer should typically be able to selectively disclose inside information to counterparties to the transaction and would be able to delay public disclosure of that information, and there should be no need to announce the information before entering into the arrangement in question.
Click here to see our recent MAR paper.
- The Institute of Chartered Accountants of England and Wales (ICAEW) has published a report entitled "What's next for corporate reporting: time to decide?" The report takes stock of where corporate reporting stands at present and identifies the key decisions to be taken before a step change in the quality and usefulness of reports can be achieved.
- The Financial Reporting Council (FRC) has published a full list of the names of companies whose audits have been reviewed by its Audit Quality Review Team in 2016/2017. The list is updated periodically. The next update will be published in September 2017.