The Financial Conduct Authority (FCA) has announced that it is proposing to use its temporary product intervention powers for the first time to restrict firms from distributing contingent convertible instruments (CoCos) to the mass retail market for a 12 month period from 1 October 2014.  The FCA is not formally consulting on these proposals, but would nevertheless welcome comments, particularly those received before the temporary rules come into force on 1 October 2014. 

Rationale

The announcement is said to reflect the FCA’s objective to secure appropriate protection for consumers, and follows announcements by ESMA and the Joint Committee of ESAs highlighting the risks of CoCos and firms’ responsibilities when selling them. 

The restrictions are also being put in place ahead of the publication of the final results of the 2014 EU-wide stress test in October 2014 by the EBA and of the ECB’s comprehensive assessment of EU credit institutions of the participating Member States, as a result of which it is likely that a number of European credit institutions may be required to undertake further capital raising.

The FCA recognises that there is no evidence of actual consumer detriment in the UK.  Although the FCA’s paper refers to issuers in some other jurisdictions having used self-placement distribution models to sell “similar” capital instruments to their retail clients, and suggests that in some cases the majority (up to 75%) of sales were to retail investors, and that the loss per customer in some cases has been over 80% of their initial investment, the source of this particular data is not clear. 

We are however aware that the Australian Securities and Investments Commission (ASIC) had issued a consumer warning in 2011 about hybrids, and took some action to improve disclosure.  This apparently failed to quench retail investors’ enthusiasm for the yield offered by the products, which were quite widely sold to retail investors in Australia.  ASIC was concerned not merely that retail investors may have had the impression that CoCos were a debt equivalent, and more secure than they are in reality, but also that fund managers may have been inappropriately been including CoCos within the “fixed income” part of their portfolios.

The FCA says that to date it has used supervisory measures on a case-by-case basis to protect the UK retail market from consumer detriment arising in respect of CoCo issuances.  There are indications that the amount of CoCos in the market is likely to increase rapidly in the coming years, and the growing number of issuances is likely to put increasing strain on this approach.  The FCA also notes that it cannot influence non-UK issuances. 

The restrictions

The rules will apply to all authorised persons in the UK, including both issuers of CoCos and firms promoting or intermediating transactions in CoCos eligible as either AT1 or Tier 2 (T2) capital under Regulation (EU) No 575/2013 (the Capital Requirements Regulation).  The rules will generally not permit firms to sell, promote or intermediate transactions in CoCos that would result in ordinary retail investors investing in CoCos. 

However, to the extent that a firm’s activities amount to MiFID or equivalent third country business, the rules only apply restrictions in respect of promotional activities – and not to the sale or intermediation of the transaction in CoCos.  The FCA stresses however that firms engaging in MiFID or equivalent third country business must not only comply with the restrictions on promotion introduced by the temporary rules, but also with current applicable regulatory requirements, notably the client’s best interest rule (COBS 2.1.1R), and the suitability (COBS 9) and appropriateness (COBS 10) rules.

The rules will also not:

  • affect the distribution of CoCos to professional or institutional clients, or to exempt persons;
  • restrict the distribution of prospectuses issued in compliance with the Prospectus Directive;
  • apply to clearing, registration, settlement, custodial or back office processing services; or
  • cover indirect exposure via investment funds or occupational pension schemes. 

They will, however, apply even if there is no client relationship between the firm and the retail investor (as may be the case in relation to sales by the issuer, for example).

The temporary restrictions will apply to the distribution of new issues and of investments on the secondary market, including promotions to UK investors of securities issued abroad.

There are exemptions proposed in respect of retail investors certified as high net worth investors, sophisticated investors, or self-certified sophisticated investors, or where the consumer has specifically requested advice without receiving previous communications from the firm about investment in CoCos – unsurprisingly, there are record-keeping conditions attached. 

The rules will allow an ordinary retail investor who does hold a CoCo to receive advice from a regulated firm about whether the investment remains suitable or should be reinvested, but will prevent further investment by ordinary retail investors.

The FCA has also indicated that the waivers process would potentially be available to firms subject to the temporary rules waiver, if the firm is able to demonstrate that (a) complying with the rule would be unduly burdensome or would not achieve its purpose, and (b) the waiver would not adversely affect any of the FCA’s operational objectives.

Next steps

Sept 2014   – FCA will consult on permanent product intervention rules on CoCos

Oct 1, 2014 – Temporary product intervention rules take effect

Q2 2015       – FCA will publish a policy statement on the proposed permanent rules

Oct 1, 2015 – Final rules will take effect (temporary rules expire)

Comment

This first foray by the FCA into the use of product intervention powers will be closely watched by regulators across Europe, who will soon acquire equivalent powers to restrict the marketing, distribution or sale of financial instruments under MiFIR (ironically it is MiFID that prevents the FCA from extending the ban to covers sales by firms engaging in MiFID or equivalent third country business).  

In exercising this power, the regulator notes that limiting access to CoCos is compatible with ensuring that distributors of investments compete to promote suitable – rather than unsuitable – investments to ordinary retail investors.  The detailed list of considerations is set out at Annex 1 of the paper, and include a number of “contextual” considerations:

  • the potential scale of detriment in the market (expected increase in number of issuances)
  • the potential scale of detriment to individual customers (concern that higher rates of return will be particularly attractive to clients with most of their net wealth held in deposits)
  • the social context (people in retirement searching for better interest rates than are available on cash accounts being at greatest risk)
  • the market context (potential for behavioural biases to drive unsuitable sales in this market – detriment not remediable through requiring enhanced disclosure or advised sales)
  • possible unintended consequences for capital raising (supervisory approach to date have not damaged the ability of issuers to raise capital).

In a somewhat throwaway line, designed to encourage firms intending to rely on the exemptions to take particular care to safeguard the interests of sophisticated or high net worth retail clients, the FCA expresses growing concern that even professional investors may not be properly evaluating and pricing CoCos.   This is interesting because CoCos present regulators, who have actively encouraged their issuance for regulatory capital purposes, with some potential conflicts of interest.  There is a strong regulatory interest in maintaining a market in CoCos.  And like other regulators, the FCA requires a significant proportion of deferred remuneration of bank employees to be paid in “bail-inable” debt (or equity).