Red herrings for most offerings of structured products registered with the Securities and Exchange Commission (the "SEC") under the Securities Act of 1933, as amended (the "Securities Act"), are usually prepared and filed in one of two ways:

  • Preliminary pricing supplements ("PPSs"), which are filed with the SEC under Rule 424(b) under the Securities Act; or
  • "Free writing prospectuses," which are filed with the SEC under Rule 433.

This article explains the difference between these two, and describes some of the reasons why market practice varies as to their use.

Preliminary Pricing Supplements Rule 424(b)

Once upon a time, when most of our readers were very young (that is, before December 1, 2005), there was no such thing as a "free writing prospectus." Any written offering document, subject to very limited exceptions, had to be in the form of a statutory prospectus. For purposes of a "red herring," or PPS, the SEC rules permitted a limited amount of pricing-dependent information to be omitted, e.g., principal amount, final interest rate, etc.

Needless to say, PPSs are long and detailed (especially when attached to an issuer's MTN prospectus supplement, supplementing the issuer's base prospectus). In addition, these documents are not necessarily presented in a manner that is useful to all investors.

Free Writing Prospectuses Rule 433

In 2005, the SEC introduced "Securities Offering Reform" and related rules, which permitted the use of a wide range of written materials relating to structured notes and other offerings, in addition to the statutory prospectus.1 Structured products professionals at first viewed the rule as a useful basis for creating brochures, term sheets and other materials that could help explain structured products more efficiently. However, many market participants quickly realized that, particularly when investors are familiar with the relevant issuer and the product class, a red herring could be issued in this manner. Especially when hyperlinks to the issuer's base prospectus and prospectus supplement are added, the "styling" of a red herring as an FWP enables broker-dealers to provide a slimmer and a more convenient document for conveying the preliminary terms of an offering to investors.

Of course, in addition to their potential use as a preliminary offering document, FWPs can be used to summarize the terms of an offering, or to provide additional information that may be useful to investors. However, in this article, we will focus on the use of FWPs as a substitute for traditional PPSs.

How is a PPS Different from an FWP?

In practice, an FWP and a PPS need not be very different.2 However, there are a few items that we should point out.

SEC Filing Requirement. Under Rule 433, an FWP must be filed with the SEC by 10:00 p.m. Eastern time on the date of first use. In contrast, under Rule 424(b), a PPS must be filed within two business days of its first use. In practice, a number of distributors will want the FWP or the PPS filed as soon as possible with the SEC, even if the SEC rules permit a "delay" of two business days for a PPS. For example, these distributors may use the links to the documents on the SEC website as one of the means by which they disseminate information about the offering to investors or to their own financial advisors. In addition, depending upon the suite of relevant offering documentation, the link to the red herring may also need to be included in other FWPs relating to the offering. Accordingly, timing may be of the essence for the filing of both FWPs and PPSs.

To many, the different timing requirements, that is, the "same day" requirement of Rule 433, as compared to the "two business day" requirement of Rule 424(b), is not particularly intuitive, especially when both documents are used for a comparable purpose. However, the invention of the FWP in 2005 was a relatively significant step for the SEC in 2005, and accordingly, the same-day filing requirement was in part designed to help ensure that offerees could obtain the benefit of any material information that is set forth in an FWP. It is not clear that the SEC anticipated that FWPs would be used as a substitute for a more traditional PPS.

Rule 433 Legend. An FWP (but not a PPS) must include a legend required by Rule 433, which refers to the issuer's prospectus that has been filed with the SEC, and provides a toll-free number by which an investor can obtain that document.3

Attaching Base Prospectuses. Market practices vary, but FWPs are less likely to be delivered to investors with the base prospectus and prospectus supplement attached. Of course, before the adoption of Securities Offering Reform, and the popularization of electronic delivery of prospectuses and other offering documents, PPSs were delivered to investors in paper form with copies of the base prospectus and prospectus supplement attached.

Why Would an Issuer Decide to Use a PPS or an FWP?

Ineligible Issuers. For starters, some structured note issuers cannot use an FWP in place of a PPS. For example, "ineligible issuers" and their distributors may not use FWPs for their offerings, except for the limited purpose of providing preliminary terms of a security.4 Accordingly, a significant number of structured note issuers, which previously used FWPs for their red herrings, have changed their approach to use PPSs, when they became "ineligible issuers."

Liability Considerations. In terms of liability considerations, an FWP that contains material misstatements or omissions should be viewed in a similar manner as a PPS (or final pricing supplement). If there are misstatements in an FWP, these would trigger liability under Section 12 of the Securities Act in a manner comparable to that for a PPS.

Flexibility. Because a PPS is subject to Regulation S-K, a variety of detailed form and content requirements apply, some of which are "non-negotiable." If a product manufacturer wishes to use a different format to market a red herring, for example, by using a cover page that does not conform to the specific requirements of Regulation S-K, then an FWP may be a more suitable approach.

Disclosure Philosophy. Which is better? A short document, which might be more inviting for an investor to read? Or a longer document, which the reader might immediately discard? On the one hand, many market participants believe that an FWP that links to the longer base documents can include sufficient disclosure for most or all retail investors. On the other hand, other market participants believe that placing the full PPS in front of the reader helps to remove any concerns about the adequacy of the disclosure package. Accordingly, practice varies.

PRIIPs Implementation Date Fast Approaching

As mentioned in our Volume 8, Issue 75 publication of Structured Thoughts, the EU Packaged Retail Products and Insurance-Based Products Regulation (the "PRIIPs Regulation") will become effective on 1 January 2018.

Requirement for Preparation of a KID

From the start of 2018, any product within the scope of the PRIIPs Regulation can only be sold to an EU retail investor (including a retail client under MiFID II) if a Key Information Document ("KID") is provided in advance to such investor. The KID is intended to be a short-form pre-contractual disclosure document and must not exceed three pages of standard-sized text. The PRIIPs Regulation, together with the Regulatory Technical Standards ("RTSs") set out detailed and prescriptive criteria for the information to be included in the KID.

Scope of the PRIIPs Regulation

For non-insurance products to come within the scope of the PRIIPs Regulation, the amount repayable to investors has to be subject to "fluctuations because of exposure to reference values to the performance of one or more assets which are not directly purchased by the investor." It will not therefore apply to "vanilla" fixed, or floating, rate notes. However, many or most structured products are likely to come within the scope of the PRIIPs Regulation, and any issuer of a product that embeds a derivative or makes any payment of principal, interest or other amount by reference to the value of any asset or index should consider carefully whether the PRIIPs Regulation will be relevant.

Although the territorial scope of the PRIIPs Regulation is not clear on its face, the EU Commission has published guidelines that state that a KID will need to be provided where an in-scope product is made available to EU retail investors (whether or not the product manufacturer or distributor is based outside the EU). However, no KID needs to be provided to any investors located outside the EU, even where the issuer or distributor is within the EU.

Points for Issuers and Manufacturers to Consider

It is important for any issuer/manufacturer of a product that comes within the definition of a PRIIP that may find its way to EU retail investors to either ensure that it is able to comply with the obligation to prepare a KID for such product or to take steps to ensure that it cannot be sold or transferred to EU retail investors. Two key issues here for product manufacturers to bear in mind are:

  • Where a PRIIP is to be made available to an EU retail investor, the obligation to prepare the KID is on the product manufacturer (even if based outside the EU). The obligation to deliver the PRIIP to the investor lies with the person advising on or selling the PRIIP to the retail investor. Therefore, although a distributor should not be selling a PRIIP to an EU retail investor unless it knows that the manufacturer has prepared or is preparing a KID, manufacturers should ensure that their distributors are fully aware as to whether the product can be made available to EU retail investors, and that relevant contractual selling restrictions and offering legends reflect this position.
  • The PRIIPs Regulation applies to sales in the secondary as well as the primary markets and the obligation to produce the KID is still the product manufacturer's in respect of secondary sales. It is therefore important that the whole chain of distributors, be bound by relevant selling restrictions. It is also advisable, where a product is not intended to be sold to EU retail investors, to ensure there is a prominent legend to this effect on the relevant offering documents.

Market Standard Legends and Selling Restrictions

The International Capital Markets Association ("ICMA") has been working with the industry to develop forms of PRIIPs legends and selling restrictions. It has developed language for two options: first, where there is to be a blanket prohibition on sales to EU retail investors (in this case, there is alternative language for standalone issues and for programs where no issuance can be sold to a retail investor); and second, a form of legend/restriction for program issuances that can be switched on or off, depending on whether the particular issuance is to be made available to retail investors.

It they have not already done so, we would recommend that all issuers and manufacturers of packaged or structured products that could be sold into the EU in either the primary or secondary markets consider whether such legends and selling restrictions should be incorporated into their products, and review their contractual arrangements with their chain of distributors.