On August 5 2014 the Financial Conduct Authority (FCA) published a press release announcing that it is using its temporary product intervention rules to restrict the distribution of contingent convertible instruments ('cocos') to professional, institutional and sophisticated or high-net-worth individuals from October 1 2014 to October 1 2015, ahead of consultation on permanent rules later this year. This is the first time that the FCA has exercised its product intervention powers to restrict the sale of a product for consumer protection reasons.
The FCA has stated that it does not believe that cocos are appropriate for distribution to the mass retail market. While the FCA is in the final stages of preparing its awaited consultation on the marketing of cocos, the authority thought it prudent to put in place temporary rules pending consultation on and finalisation of permanent rules.
In summary, authorised persons in the United Kingdom (including issuers of cocos and firms promoting or intermediating transactions in cocos) may not sell cocos (whether issued by UK or overseas institutions) to 'ordinary' retail clients in the European Economic Area (EEA) or do anything that will or might result in the buying or holding of cocos by a retail client in the EEA.
The FCA believes that cocos are highly complex instruments which present investment risks that are difficult to evaluate and model, even for professional investors. Their features are dictated by regulatory capital requirements and the requirement not to meet an identified need of target investors; consequently, the FCA believes that cocos are not generally suitable for the retail market.
The FCA's reasoning for this first intervention is noteworthy. It has previously sought to ensure that cocos are marketed in a way that minimises inappropriate investment by ordinary retail investors by asking UK banks to use high denominations voluntarily. However, given the expected increase in the number of new issues of cocos by UK banks and non-UK banks (with which the FCA may be unable to seek voluntary agreement to use high denominations), the FCA believes that it needs a more certain solution to ensure that retail investors are appropriately protected.
The rules do not apply to professional or institutional clients or to exempt persons. Subject to certain conditions, authorised persons in the United Kingdom may sell, promote or intermediate transactions in cocos to high-net-worth investors, sophisticated investors and self-certified sophisticated investors. To the extent that a firm's activities amount to engaging in EU Markets in Financial Instruments Directive or equivalent third-country business, the temporary rules apply restrictions only to promotional activities and not to the sale or intermediation of transactions in cocos. Suitability and appropriateness assessments may need to be performed and obligations to act in the client's best interest still apply. Accordingly, firms should ensure that they have appropriate systems for documenting and keeping records of eligibility.
Notably, the rules do not:
- prohibit indirect exposure via investment funds or occupational pension schemes;
- restrict the distribution of prospectuses issued in compliance with the EU Prospectus Directive; or
- apply to clearing, registration, settlement, custodial or back-office processing services.
The FCA consultation paper on permanent rules on the marketing of cocos is expected in September 2014. Following receipt of feedback to the consultation paper, the FCA expects to publish its policy statement in the second quarter of 2015, with the final rules taking effect from October 1 2015.
Implications for issuance of cocos
In the existing low-interest-rate environment, many investors have understandably turned to cocos in their search for yield in order to boost investment returns. The European Securities and Markets Authority's recent step of publishing a warning on the risks of cocos as an investment class clearly demonstrates its concern that investors do not fully appreciate these risks and have not adequately priced them in. This will inevitably lead to increased risk disclosure in prospectuses. The FCA's step of temporarily banning the sale, promotion or intermediation of transactions in cocos to 'ordinary' retail clients was to be expected and reflects concerns raised by a number of market participants over the past few years on appropriate investors in this asset class.
Implications of FCA intervention
This is the first time that the FCA has used its product intervention powers and it will be closely watched by regulators across Europe, which will soon acquire equivalent powers to restrict the marketing, distribution or sale of financial instruments under the EU Markets in Financial Investments Regulation. In the wider context of FCA intervention, it is notable that the FCA has:
- monitored coco issuance in other markets and been concerned about non-UK issuance, over which it has no control; and
- positioned its intervention partly to safeguard investor interests and partly as a more appropriate and efficient use of FCA resources.
Actions for firms following FCA intervention
The FCA's new rules are broadly drafted and firms issuing cocos or structuring or arranging coco issuance will need to consider:
- inserting disclosure in prospectuses specifying that cocos should not be sold to ordinary retail investors in the EEA (eg, in the "important notices" and "subscription and sale" sections);
- inserting additional undertakings or covenants in any distribution agreements to ensure that any distributors (in the United Kingdom as well as more widely across the EEA) are under a contractual obligation to sell in accordance with the FCA's new rules; and
- reviewing global product governance, distribution and origination policies to mitigate the risk of distributors and investors that receive cocos on initial allocation selling in breach of the new regime.
While the FCA's new rules will not directly apply to non-FCA-regulated firms, UK regulated issuers and arrangers will need to take safeguards to ensure that any non-UK authorised firm involved in a transaction does nothing that will or might result in the buying of a coco or the holding of a beneficial interest in a coco by a retail client in the EEA. Failure to do so may result in the FCA-regulated firm being in breach of the new rules.
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