OverviewTypical types of transactions
Other than transactions between dealers, what are the most typical types of over-the-counter (OTC) equity derivatives transactions and what are the common uses of these transactions?
OTC equity derivatives have a range of common uses, as outlined below.
One of the most common forms of OTC equity derivatives is margin loans, where a party that holds shares borrows cash and uses those shares as collateral for the borrowing. The purpose of margin loans is for shareholders to ‘monetise’ their shareholdings.
Margin loans can either be on a full recourse basis or limited to the value of the shares posted as collateral. A limited recourse margin loan is sometimes drafted as a put option (whereby the counterparty can effectively put the shares to the bank in satisfaction of its obligations under the loan). A prepayment feature represents the initial extension of the ‘loan’. In some transactions counterparties ‘pay for’ the limited recourse feature represented by the put option by simultaneously selling a call option to the bank. Such a transaction is drafted as a collar transaction where the counterparty is protected from a fall in value of the shares and the bank benefits from the upside.
Other common OTC equity derivatives transactions involve buy-backs of shares by companies. Buy-backs can be drafted as put options sold to counterparties (giving a counterparty a right to put shares back to the company when the price falls), call options purchased by the company or forwards. A common transaction involves a forward transaction that is settled when the volume weighted average price of shares drops below a certain level. Companies enter into buy-back arrangements to manage their capital base (and purchase shares when the company believes the shares to be good value) or as part of the management of employee share schemes.
Private equity transactions
OTC equity transactions are sometimes used in private equity transactions. A purchaser of a stake in a company might be given as part of the deal in a call option to purchase additional shares of the company (which it would exercise if the perceived value of the company increased). Similarly, a purchaser may require a put option from the vendor giving it a right to put the shares back to the company if the acquired company’s performance did not meet expectations.
Occasionally, loan transactions are combined with call options as a way of enhancing return to the lender. Such equity upside is sometimes given by corporates in exchange for better pricing or other more favourable terms.
Other uses of OTC equity derivatives include enhancement of portfolio return - and many such transactions feature bespoke pay-offs, linked to the performance of one or more equities or indices. These are particularly common in the context of securitised derivatives, often aimed at the retail market. Funds also regularly take exposure to equities using equity derivatives.
OTC equity derivatives are also used to allow investors access to equity markets that are closed to direct investment from European investors. Shares are often in emerging market jurisdictions, but the transactions may be arranged in the UK for European investors. A local bank would purchase the shares directly and pass the return to European investors through the use of equity derivatives.
OTC equity derivatives transactions are sometimes used for stake building (often in preparation for takeover bids). This use of equity derivatives has become less common in light of rules that now require greater transparency of positions, even in cash-settled derivatives; however, they are still sometimes used for leverage purposes.Borrowing and selling shares
May market participants borrow shares and sell them short in the local market? If so, what rules govern short selling?
Yes, short selling is permissible and is governed by the Short Selling Regulation (Regulation No. 236/2012) (SSR). The SSR applies to EU-listed shares (unless they are primarily traded on a third-country venue), subject to certain exemptions for market making. Transparency rules under the SSR require that a person who has:
- a net short position that reaches or falls below 0.2 per cent of the issued share capital of the company concerned must disclose it to the Financial Conduct Authority (FCA) (and each movement through a 0.1 per cent threshold above 0.2 per cent); and
- a net short position that reaches or falls below 0.5 per cent of the issued share capital of the company concerned must disclose it to the market (and each movement through a 0.1 per cent threshold above 0.5 per cent).
A person who sells short is also required to have borrowed (or put in place arrangements to borrow or acquire) the shares.
The SSR also allows regulators to impose temporary restrictions on short selling if a serious threat to financial stability or market confidence arises.Applicable laws and regulations for dealers
Describe the primary laws and regulations surrounding OTC equity derivatives transactions between dealers. What regulatory authorities are primarily responsible for administering those rules?
Historically, derivatives transactions between dealers have been subject to minimal regulation. There is a general authorisation requirement for dealers under the Financial Services and Markets Act 2000 (FSMA) and high-level requirements that apply to such dealers (eg, on observing proper standards of market conduct). While there are no particular regulations for equity derivatives, the European Market Infrastructure Regulation (Regulation No. 648/2012) (EMIR) applies to all derivatives transactions. EMIR requires transactions to be reported to regulators, and for transactions between dealers to be cleared or subject to other risk mitigation techniques, including collateralisation. EMIR is administered in the UK by the FCA. In addition, certain corporate regulatory rules (in particular as regards disclosure) may apply to equity derivatives transactions.
From 3 January 2018, the Markets in Financial Instruments Directive (Directive 2014/65/EU) and Regulation (Regulation No. 600/2014) (MiFID II/MiFIR) applied in the EU. Among other reforms, MiFID II/MiFIR introduced a trading obligation for derivatives (which generally applies to some of the most liquid and standardised products, including interest rate swaps and index credit default swaps (CDS)) and increased the scope of the price transparency and transaction reporting regimes. Under MiFID II/MiFIR, certain transactions in derivatives pertaining to a class of derivatives declared subject to the trading obligation may only be concluded on a trading venue in the EU (ie, a regulated market, a multilateral trading facility or an organised trading facility) or certain third-country trading venues in relation to which an equivalence determination has been made by the European Commission, subject to limited exceptions (eg, intra-group transactions). MiFID II/MiFIR also impose pricing transparency obligations on derivatives that are traded on a trading venue, including in respect of OTC transactions in those derivatives.Entities
In addition to dealers, what types of entities may enter into OTC equity derivatives transactions?
There are no general exclusions on the types of parties that can enter into OTC equity derivatives transactions, although, depending on the business model, nature and frequency of such parties’ activities, this may require regulatory authorisation.Applicable laws and regulations for eligible counterparties
Describe the primary laws and regulations surrounding OTC equity derivatives transactions between a dealer and an eligible counterparty that is not the issuer of the underlying shares or an affiliate of the issuer? What regulatory authorities are primarily responsible for administering those rules?
EMIR applies to all derivatives transactions (and is not specific to equity derivatives). The requirements of EMIR (eg, regarding the obligation to clear or to post collateral in respect of derivatives) depend on the nature of the counterparties. In general, the most onerous obligations apply to transactions between dealers, and less onerous requirements apply to transactions between a dealer and a corporate entity with a small derivatives book.
MiFID II/MiFIR also apply to all derivatives transactions (and are not specific to equity derivatives). Under MiFID II/MiFIR, the scope and precise nature of the applicable pricing transparency obligations (eg, whether post-trade transparency applies and whether the deferral of post-trade publication is permitted) depends on whether the derivative is of a type that is traded on a trading venue (in which case the post-trade transparency obligations apply) and whether there is deemed to be a liquid market in the relevant product or the transaction is above a certain size (in which case it may be possible to defer publication of the trade). In respect of the UK, the European Securities and Markets Authority (ESMA) is currently responsible for calibrating the relevant thresholds and the scope of the requirements. There are certain exclusions from the scope of the pricing transparency obligations, including in respect of transactions that do not contribute to the price discovery process, such as a transfer of margin or collateral, the exercise of a right embedded in a financial instrument, or a decrease or increase in the notional amount of a derivative contract as a result of pre-determined contractual terms or mandatory events. Firms that are ‘systematic internalisers’ in a particular product are also subject to pre-trade price transparency obligations, though these obligations only apply where a client approaches a dealer on a request for quote basis and there is a liquid market in the relevant product.
The FCA is primarily responsible for administering EMIR and MiFID II/MiFIR as applicable or implemented in the UK in this context and has a range of investigatory and enforcement powers that it can exercise in relation to non-compliance.Securities registration issues
Do securities registration issues arise if the issuer of the underlying shares or an affiliate of the issuer sells the issuer’s shares via an OTC equity derivative?
There are no particular securities registration issues that arise if the issuer of the underlying shares (or its affiliate) sells the issuer’s existing shares via an OTC equity derivative.Repurchasing shares
May issuers repurchase their shares directly or via a derivative?
Yes, issuers may repurchase their own shares, either in direct transactions (which will typically be on-market) or indirectly through derivatives that are physically settled.
Under general company law, a buy-back of shares by a public company is permitted if the buy-back is not restricted by the articles of association of the issuer; authorised by a resolution of shareholders; and paid for out of distributable profits or the proceeds of a fresh share issue, which is made for the purpose of financing the buy-back.
By virtue of the fact that cash-settled OTC derivatives transactions will not result in an acquisition of shares, they will not be subject to the UK rules concerning repurchases of shares.
Companies subject to the UK listing rules will also need to consider whether additional listing rules requirements apply in the context of a repurchase of an issuer’s shares. For example:
- there are certain times where an issuer cannot buy back its shares (unless an exemption applies);
- the rules relating to transactions with a related party may apply;
- depending on the number of shares to be repurchased, the price payable and who the buy-back is offered to will need to be considered; and
- there will generally be notification requirements.
In addition, it is unlawful for a public company or its subsidiary to provide financial assistance for the purchase of the public company’s shares. Share repurchases undertaken in accordance with the relevant provisions of the Companies Act 2006 are specifically excepted. However, there is a possibility that an issuer giving financial assistance in connection with a buy-back (eg, by borrowing money and granting security in respect of the borrowing) may be within the scope of the prohibition.Risk
What types of risks do dealers face in the event of a bankruptcy or insolvency of the counterparty? Do any special bankruptcy or insolvency rules apply if the counterparty is the issuer or an affiliate of the issuer?
Assuming the counterparty is a UK-incorporated company, dealers would face ordinary commercial risk on their counterparties. There are no particular additional risks in the context of equity derivatives. If the counterparty is also the issuer of the shares, a transaction could potentially invoke the anti-deprivation rule under English law, which is a public policy rule that provides that a party cannot divest itself of its assets on its insolvency. It is not obvious, however, that a typical transaction that is linked to the value of shares (rather than a transaction that provides for a payout by an issuer that is triggered by a party’s insolvency) would invoke this rule. That said, it is important to consider the anti-deprivation rule when parties are entering into ‘self-referencing’ derivatives transactions.
If the counterparty is a financial institution, the Bank Recovery and Resolution Directive (Directive 2014/59/EU) (BRRD) gives regulators powers to, inter alia, stay termination rights under contracts and impose ‘bail-in’ or loss-sharing on contractual counterparties, which could apply to the net position under derivatives contracts. The BRRD is not directed in particular at OTC equity derivatives. In the UK, the BRRD was primarily implemented through amendments to the Banking Act 2009 and the FCA and Prudential Regulation Authority (PRA) rule books. The Bank of England has been designated as the UK’s resolution authority for the purposes of the BRRD and is responsible for exercising the BRRD resolution powers such as bail-in.Reporting obligations
What types of reporting obligations does an issuer or a shareholder face when entering into an OTC equity derivatives transaction on the issuer’s shares?
Issuers may be subject to reporting obligations in respect of buy-back programmes and stabilisation under the Market Abuse Regulation (Regulation No. 596/2014) (MAR). Issuers and shareholders may also have notification obligations in respect of OTC equity derivatives transactions on the issuer’s shares, which are considered in question 14. Regulated investment firms (which may include issuers and shareholders) may also be subject to certain transaction and trade reporting obligations under MiFID II/MiFIR, which are considered in question 28.Restricted periods
Are counterparties restricted from entering into OTC equity derivatives transactions during certain periods? What other rules apply to OTC equity derivatives transactions that address insider trading?
The general rules relating to insider dealing and market abuse may apply to any counterparty of an OTC equity derivatives transaction that references qualifying investments admitted to a prescribed market. MAR has direct effect in the UK and, together with the FSMA, sets out the civil regime (which is supplemented by guidance issued by the FCA), while the Criminal Justice Act 1993 (CJA) sets out the criminal regime.
In broad terms, a counterparty must not enter into, or attempt to enter into, a relevant transaction on the basis of ‘inside information’ - essentially, information of a precise nature that is not publicly available and that would be likely to significantly affect the price of the securities if it were generally available. Additional prohibited behaviours include unlawful disclosure of inside information and market manipulation (including attempted market manipulation) in the form of, for example, the giving of false or misleading signals as to the supply or price of a financial instrument or through the use of fictitious devices or deception (eg, pump and dump). There are also rules derived from MiFID II/MiFIR which restrict personal account dealing by ‘relevant persons’ at investment firms (eg, directors, employees or third-party delegates of such firms and their connected persons), who have access to inside information or other confidential information relating to clients.
These prohibitions apply equally to derivatives (whether cash-settled or physically settled) as well as direct dealings in shares.
In addition to general insider dealing and market abuse rules, if the counterparty to an OTC equity derivatives transaction involving shares in an issuer is a ‘person discharging managerial responsibility’ in respect of that issuer (broadly, directors and certain senior executives), that person (and their connected persons) must not deal in the issuer’s securities during certain prohibited periods and any period when there exists any matter that constitutes inside information in relation to the issuer.Legal issues
What additional legal issues arise if a counterparty to an OTC equity derivatives transaction is the issuer of the underlying shares or an affiliate of the issuer?
This will depend on the specific circumstances of the transaction, but may include one or more of the following.
UK-listed issuers are prohibited from dealing in their securities during any period when there exists any matter that constitutes inside information in relation to the issuer.
In addition, English law requirements in relation to capital maintenance provide that it is unlawful for an issuer to make a distribution of its assets to its members (whether in cash or otherwise) other than out of distributable profits. Therefore, a transaction whereby an issuer effectively supported the price of a shareholder’s holding through a derivatives transaction is likely to be problematic if the issuer does not have sufficient distributable profits, because this would have the effect of transferring value from the issuer to the shareholder if the price of the issuer’s shares fell. Although in some circumstances a transaction between an issuer and a shareholder that is negotiated at arm’s length and in good faith will not be unlawful, even where it results in a transfer of value from the issuer not covered by distributable profits, each case is judged on its particular merits and substance and there is no certainty as to how any particular OTC equity derivatives transaction will be treated.
Under English law, a subsidiary must not hold shares in its UK holding company, unless an exemption applies. Accordingly, in practice, it would be difficult for a subsidiary of a UK company to physically settle a derivatives transaction over the shares in that UK company.Tax issues
What types of taxation issues arise in issuer OTC equity derivatives transactions and third-party OTC equity derivatives transactions?
The main relevant tax is the stamp duty reserve tax (SDRT), which applies where a person agrees with another person to transfer chargeable securities for consideration in money or other value. The charge is currently 0.5 per cent of the price paid. SDRT could potentially apply to shares of a company incorporated in the UK or a foreign company with a register kept in the UK (eg, most shares listed in the UK). The cost of SDRT is typically paid by the purchaser of the shares. Although more commonly seen in on-market transactions, SDRT could equally apply to OTC equity derivatives transactions - for example, a forward sale of shares would prima facie be subject to SDRT. SDRT would not apply to cash-settled derivatives.
The Finance Act 1986 confers certain important exemptions from SDRT. Relevant exemptions include stock lending relief (in relation to stock lending transactions) and intermediary relief (in relation to transfers to market intermediaries or dealers). Even if one of the parties is an intermediary and the other party is not, a transfer from the intermediary to the other party could still give rise to SDRT.Liability regime
Describe the liability regime related to OTC equity derivatives transactions. What transaction participants are subject to liability?
There is potential for contractual liability, statutory liability and common law liability. Statutory liability may arise under EMIR or other legislation including the FSMA, MAR or CJA. The penalties for breach can include criminal penalties.Stock exchange filings
What stock exchange filings must be made in connection with OTC equity derivatives transactions?
In general, market participants should be conscious of the Disclosure Guidance and Transparency Rules (DTRs), which require a person to notify the issuer (and the FCA for shares traded on a regulated market) of the percentage of voting rights held or deemed to be held by it through a direct or indirect holding of financial instruments where the holding reaches, exceeds or falls below certain thresholds. The thresholds that trigger a notification obligation are:
- UK companies: 3 per cent and each 1 per cent above; and
- non-UK issuers: 5 per cent, 10 per cent, 15 per cent, 20 per cent, 25 per cent, 30 per cent, 50 per cent and 75 per cent.
The regime applies equally to both cash-settled and physically settled equity derivatives transactions that are unconditional (eg, derivatives transactions where the right to settle only exists where the market price reaches a certain level will not be disclosable).
The DTR disclosure regime only applies to equity derivatives with long positions. Disclosure obligations in relation to equity derivatives with short positions are considered in question 2.
Various exemptions from the DTR disclosure regime apply. In addition, holdings of equity derivatives referenced to a basket or index of shares will only need to be disclosed if certain thresholds are met that are different from those above. Certain instruments held by a ‘client-serving intermediary’ may also be exempt from disclosure. Further, notification of OTC equity derivatives transactions are only required if they are referenced to shares that are already in issue, so warrants, options or convertible bonds in respect of shares that are not yet in issue will not be disclosable.
Where a holder of shares or qualifying financial instruments provides a required notification to the issuer of a transaction that triggers one of the above thresholds, the issuer is then required to announce that information to the public.
While not stock exchange filings, market participants should also be aware of, among others, the following additional notification requirements:
- Companies Act 2006 (section 793): this imposes certain notification requirements on parties (and others) if the issuer requests them to disclose their interest in the shares. This requirement would apply to physically settled equity derivatives (even if conditional), but not cash-settled derivatives.
- takeovers: the Takeover Code imposes additional notification requirements in respect of certain public companies during an offer period.
What types of documents are typical in an OTC equity derivatives transaction?
An OTC equity derivatives transaction is typically documented under a confirmation forming part of an International Swaps and Derivatives Association (ISDA) Master Agreement. The confirmation would incorporate the relevant equity definitions, typically the 2002 Equity Derivatives Definitions. Although ISDA has published a new set of definitions, the 2011 ISDA Equity Derivatives Definitions, these are not currently commonly used by the market.
Depending on the type of transaction, security is taken over shares. It is common to have bespoke collateral documentation and custody agreements. Margin loans are commonly drafted using ISDA documentation or Loan Market Association documentation.Legal opinions
For what types of OTC equity derivatives transactions are legal opinions typically given?
In line with other derivatives transactions, opinions between dealers are rare for ‘vanilla’ equity derivatives transactions. Often dealers will seek capacity and authority opinions from non-dealer counterparties. In addition, if the documentation for transactions becomes more bespoke (eg, a tailored margin loan with a security package) enforceability opinions become more common.Hedging activities
May an issuer lend its shares or enter into a repurchase transaction with respect to its shares to support hedging activities by third parties in the issuer’s shares?
In principle, an issuer may lend its shares or enter into a repurchase transaction to support hedging activities in its shares by third parties if the issuer’s directors are satisfied that this will promote the issuer’s success. The legal issues that are relevant will depend on the exact nature of the arrangement, but may include financial assistance, capital maintenance, and market abuse and insider dealing considerations.Securities registration
What securities registration or other issues arise if a borrower pledges restricted or controlling shareholdings to secure a margin loan or a collar loan?
There are no particular securities registration issues relating to this type of activity.
However, lenders should check the issuer’s articles of association to confirm whether they contain any relevant restrictions relating to the taking of security over shares.
In addition, if security is created over shares, the Companies Act 2006 should be considered in relation to registration requirements. Most charges created on or after 6 April 2013 can be registered at the UK’s Companies House. If a charge is not registered correctly and within the relevant time frame, then the charge will be void against a liquidator, administrator or another creditor of the company.Borrower bankruptcy
If a borrower in a margin loan files for bankruptcy protection, can the lender seize and sell the pledged shares without interference from the bankruptcy court or any other creditors of the borrower? If not, what techniques are used to reduce the lender’s risk that the borrower will file for bankruptcy or to prevent the bankruptcy court from staying enforcement of the lender’s remedies?
In general, a secured party would be able to seize and sell the shares. Typically, collateral arrangements for margin loans would be designed to fall within the scope of the Financial Collateral Directive (2002/47/EC), which has been implemented in the UK. Broadly speaking, any title transfer security arrangement or a properly constructed charge should fall within the scope of the Directive (although even if a title transfer arrangement did not fall within the scope of the Directive the effect under English law would be, for all practical purposes, the same).
In circumstances other than title transfer arrangements, to fall within the scope of the Directive, it is necessary for shares to be in the ‘possession or under the control’ of the secured party. Assuming the shares are in a segregated account and there are restrictions on withdrawals of the shares and the secured party retains administrative control of the account, this test will generally be met.
For arrangements that fall within the scope of the Directive, a secured party is able to appropriate the collateral and apply it against debts owed (without a need to sell the collateral, although a party may sell the collateral if it wishes). The Directive also disapplies any statutory freeze on enforcement of security that arises in connection with administration proceedings in England.Market structure
What is the structure of the market for listed equity options?
There is no centralised exchange for UK-listed equity options. Instead, listed equity options are offered by three major exchanges - the London Stock Exchange (LSE), Eurex and the Intercontinental Exchange (ICE).Governing rules
Describe the rules governing the trading of listed equity options.
The trading of listed equity options is regulated by the standardised contracts provided by the exchanges. The standardised contracts regulate, among other things, the type of contract, trading hours, trading currency, contract value, settlement style and option style.
There are also differences between the standardised contracts provided by different exchanges. For example, while the LSE offers both physically and cash-settled option contracts, both Eurex and ICE only offer physically settled contracts.
Types of transactionClearing transactions
What categories of equity derivatives transactions must be centrally cleared and what rules govern clearing?
EMIR will require most OTC derivatives transactions to be cleared, though the applicability of this obligation is subject to certain thresholds depending on the nature and size of a counterparty and its derivatives trading. This clearing obligation is coming into force in phases and currently does not apply to OTC equity derivatives, but it is expected to in future (though this is not imminent and there is no timeframe for this). The rules relating to clearing are set out in EMIR (which acts as a framework regulation) as well as subsequent technical standards, which set out further details and requirements related to the clearing obligation. Whenever a new class of OTC derivative is approved for clearing, a new set of technical standards will be published, and these will provide detailed requirements in relation to the clearing of that particular class of OTC derivative. EMIR is being amended this year by the EMIR Refit that, among other changes, will make it less likely that small financial counterparties will be required to clear derivatives. These amendments do not particularly impact equity derivatives.Exchange-trading
What categories of equity derivatives must be exchange-traded and what rules govern trading?
The types of equity derivative that are exchange-traded are typically futures and exchange-traded options. MiFID II/MiFIR introduced a mandatory trading obligation for certain derivative transactions that require such transactions to be executed on exchange or on other specified types of trading venue (see question 3). Broadly, the trading obligation only applies to a class of derivatives that is admitted to trading or traded on at least one admissible venue (the venue test) and the derivatives are determined to be sufficiently liquid (the liquidity test). The trading obligation in respect of derivatives currently applies only to certain interest rate swaps and index CDS and does not currently apply to equity derivatives.Collateral arrangements
Describe common collateral arrangements for listed, cleared and uncleared equity derivatives transactions.
For cleared OTC equity derivatives transactions, the parties will usually be required to post both initial margin and variation margin.
For uncleared OTC derivative transactions, the most common forms of collateral arrangement are title transfer or security interest. Title transfer is far more common. If the equity derivative is documented using an ISDA Master Agreement then this type of arrangement is commonly documented using a credit support annex, which will set out, among other things, the types of collateral that may be transferred, how the amount of collateral to be transferred will be calculated, the frequency of such transfers and operational details surrounding the transfer.
For listed exchange-traded equity derivatives, the rules as to collateral will be determined by the relevant clearing house. However, both initial margin and variation margin are likely to be required.Exchanging collateral
Must counterparties exchange collateral for some categories of equity derivatives transactions?
Yes. EMIR requires the exchange of variation margin between financial counterparties (broadly, banks, funds and certain other types of non-bank financial institutions) for derivatives transactions entered into from 1 March 2017. (EMIR also imposes an obligation on financial counterparties to exchange initial margin, but this obligation is coming into force on a rolling basis. It currently applies to derivatives between financial counterparties that each have outstanding derivatives books of over €1.5 trillion and will apply to such parties that each have outstanding derivatives books of over €750 billion from 1 September 2019. This threshold is currently expected to be reduced to €8 billion from 1 September 2020.) Most derivatives transactions are in scope for these margining obligations, although single stock equity options and index option transactions will be outside scope for a transitional period.
There is currently no clearing obligation in respect of OTC equity derivatives transactions, but it is expected that such a requirement will come into force in future under EMIR for certain types of OTC equity derivatives transactions.
For requirements relating to exchange-traded equity derivative transactions, see question 24.
Liability and enforcementTerritorial 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.
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).
Update and trendsRecent developments
Are there any current developments or emerging trends that should be noted?No updates at this time.