An extract from The Structured Products Law Review, 3rd Edition

Legal and regulatory framework

i US securities laws and the role of the SEC

Most structured products issued in the US market are issued as securities or certificates of deposit (CDs).

The Securities Act of 1933, as amended (the Securities Act), regulates offers and sales of securities in the United States. All offers and sales of securities must be made pursuant to a registration statement, except for certain exempt securities and exempt transactions. Every offering needs to be registered or rely on an exemption from registration: it is the specific offering that is registered, not a series or class of securities. If no exemption is applicable, under the central provision of the Securities Act, Section 5, it is unlawful to offer a security unless a registration statement has been filed as to the security, and it is unlawful to sell a security unless a registration statement is in effect as to the security.

A registration statement is a filing with the SEC that includes a base prospectus, which contains general information about the issuer and the securities being registered. Disclosure about the issuer in its annual, quarterly and other periodic reports is typically incorporated by reference into the base prospectus. The SEC is a government agency that is the primary overseer and regulator of the US securities markets. Its mission is 'protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation'.4

Registration statements are subject to review by SEC staff, although the SEC states that it 'does not evaluate the merits of securities offerings, or determine whether the securities offered are “good” investments or appropriate for a particular type of investor'.5 Registration statements become effective upon SEC declaration or, in certain cases, automatically. Filing fees are payable to register securities with the SEC (currently US $92.70 per US$1 million of securities (with effect from 1 October 2021)).

Exemptions from registration include:

  1. Rule 144A: a safe harbour exemption for resales of securities to qualified institutional buyers (essentially, large institutional investors);
  2. Regulation D: exemptions for sales of securities to accredited investors (which include certain institutional investors, as well as high-income or high net worth individuals);
  3. Regulation S: safe harbours for offers and sales that occur outside the United States; and
  4. Section 3(a)(2): an exemption for securities issued or guaranteed by a bank or a regulated US branch or agency of a non-US bank.

CDs are issued by banks and insured by the Federal Deposit Insurance Corporation up to applicable limits. Structured CDs always provide for the repayment of the deposit amount at maturity. CDs are generally not securities for the purposes of the Securities Act and, therefore, are not required to be registered thereunder. However, similar risk and disclosure considerations apply. As a result, typical market practice is for the disclosure package about a structured CD to be relatively equivalent to the disclosure package about an SEC-registered security.6

US securities laws generally impose liability for material misstatements and omissions in the offering documents. The applicable standard, persons subject to liability and potential defences depend in part on whether the securities are SEC-registered.

The typical disclosures provided to investors in SEC-registered structured product offerings can be divided into three broad categories:

  1. Disclosure about the issuer: typically, structured products are issued or guaranteed by an entity that is subject to extensive ongoing reporting requirements. Those disclosures, which are made in public filings, are typically incorporated by reference into the base prospectus or similar base offering document (such as the offering memorandum or offering circular).
  2. Disclosure about the structure and related adjustment mechanics: these disclosures are typically contained in one or more of the offering documents that supplement the base offering document (such as a prospectus supplement or product supplement or the preliminary and final pricing supplements).
  3. Disclosure about the underlying reference asset or assets. These disclosures are typically contained in one of the offering documents that supplements the base offering documents (such as an underlying supplement or the preliminary and final pricing supplements). However, under a 1996 no-action letter, the SEC staff has granted relief to issuers of securities linked to equity securities issued by another (unaffiliated) issuer (underlying company) if the issuer does not have any material non-public information about the underlying company and where there is sufficient market interest in and publicly available information regarding the underlying company. In this case, the issuer may refer investors to disclosures made by the underlying company without having to take liability for such disclosures. The SEC staff has extended this analysis to exchange-traded funds (ETFs). Starting in December 2020, issuers began to launch SEC-registered structured notes linked to actively managed ETFs. Since then, issuers have launched hundreds of offerings linked to one or more actively managed ETFs. Most issuers have included cover page and risk factor disclosure relating to active management.
ii Broker-dealer regulation and the role of FINRA

FINRA is a non-governmental self-regulatory organisation that regulates member broker-dealer firms. Most issuers of structured products are affiliated with one or more broker-dealers that are members of FINRA and need to comply with its rules. FINRA has long been focused on structured and complex products and other issues relevant to structured products, such as communications with the public, conflicts of interest, suitability and KYD policies and procedures. Some of FINRA's key relevant guidance in these areas is summarised in Section III.

iii State securities laws

Each state has its own securities laws (often referred to as 'blue sky laws'). These state laws frequently prescribe registration or qualification requirements that apply to securities, including SEC-registered securities, unless such requirements are pre-empted pursuant to Section 18 of the Securities Act. Because issuers of structured products typically list at least one class of their equity (or debt) securities on a national securities exchange, these state law requirements will be pre-empted for all of its securities (including structured products) that rank equal or senior to that listed security so long as that listed security remains outstanding and listed.

However, even if the registration and qualification requirements are so pre-empted, state securities laws may still require notice filings or payment of fees. In addition, state securities regulators retain the ability to bring actions under state laws that, for example, prohibit fraud.

iv Select bank regulatory issues applicable to structured products

On 15 December 2016, the Federal Reserve released its final rule on total loss-absorbing capacity (TLAC) and eligible long-term debt (LTD) securities (the Final Rule). The Final Rule requires the top-tier holding company of each US global systemically important banking organisation (each a covered BHC) to maintain certain minimum amounts of external eligible TLAC (consisting, essentially, of regulatory capital and eligible LTD securities) and external eligible LTD securities.

In addition, according to the clean holding company requirements in the Final Rule, a covered BHC is prohibited from directly incurring certain liabilities, including short-term debt and parent guarantees of subsidiary liabilities with certain impermissible cross-defaults. The clean holding company requirements also impose a cap on unrelated liabilities of a covered BHC at 5 per cent of its external TLAC. Unrelated liabilities generally include, among other non-contingent liabilities, any LTD securities issued by a covered BHC to third parties that are excluded from eligible LTD securities. Importantly, structured notes are excluded from eligible LTD securities. As a result, they do not count towards a covered BHC's minimum external TLAC or LTD requirements and instead are treated as unrelated liabilities that are subject to the 5 per cent cap.

The Final Rule defines structured note as a debt instrument that:

(1) Has a principal amount, redemption amount, or stated maturity that is subject to reduction based on the performance of any asset, entity, index, or embedded derivative or similar embedded feature;(2) Has an embedded derivative or similar embedded feature that is linked to one or more equity securities, commodities, assets, or entities;(3) Does not specify a minimum principal amount that becomes due upon acceleration or early termination; or(4) Is not classified as debt under GAAP, provided that an instrument is not a structured note solely because it is one or both of the following:(i) An instrument that is not denominated in U.S. dollars; or(ii) An instrument where interest payments are based on an interest rate index.

This definition clearly includes, for example, structured notes where the payment at maturity is based on the performance of one or more equities, commodities or other assets. In other cases, the analysis may be more complex and will depend heavily on the specific structure.

Another area of bank regulation that has affected structured products has been the QFC Stay Rules. These Rules were designed to improve the resolvability and resilience of US global systemically important banking organisations (G-SIBs), including their subsidiaries and branches worldwide, and the US subsidiaries, US branches and US agencies of foreign G-SIBs (covered entities), by mitigating the risk of destabilising closeouts of qualified financial contracts (QFCs) in the event of a covered entity's entry into insolvency or resolution proceedings. QFCs include derivatives, repos, securities lending agreements, and contracts for the purchase and sale of a security, among other contracts. The definition of QFC can pick up structured products in certain instances.

The QFC Stay Rules only apply to 'in-scope' QFCs: that is, QFCs that expressly include a default right7 against a covered entity or expressly restrict the transfer of the QFC (or any interest in or under or any property securing the QFC) from a covered entity. The QFC Stay Rules include two substantive requirements:

  1. a requirement that an in-scope QFC expressly recognises the FDIC's power to stay the exercise of certain default rights and transfer the QFC under the Federal Deposit Insurance Act and Title II of the Dodd-Frank Act (Express Recognition Requirement); and
  2. a requirement to expressly override certain cross-default rights against a covered entity and provisions restricting the transfer of an affiliate credit enhancement upon an affiliate of the covered entity party entering any insolvency or resolution proceedings (Override Requirement).

While structured products were not the focus of these rules, the rules were drafted such that structured products were captured in certain cases. Issuers were required to review carefully their structured product portfolio to determine whether they included QFCs and, if so, whether any of the QFCs included provisions bringing them in scope for the rules.

The QFC Stay Rules also include a number of exemptions: for example, certain in-scope QFCs governed by US law, and where all non-covered entity parties are US entities are exempted from the Express Recognition Requirement. In-scope QFCs that do not include cross-default rights against a covered entity and that do not restrict the transfer of an affiliate credit enhancement are exempted from the Override Requirement. Even if a structured product is an in-scope QFC, it has to be further analysed to determine whether an exemption is available, depending upon the specific terms of and parties to each agreement.

These rules are another example of the complex interplay between bank regulatory regimes and the sophisticated capital markets transactions that financial institutions perform.

v The enforcement environment

Structured products, especially those offered and sold to retail investors, have faced and will continue to face a very high level of regulatory and media scrutiny in the United States. This includes scrutiny in the form of enforcement actions by the SEC and FINRA.

The SEC is committed to policing all parts of the US capital markets and periodically reviews filings related to offerings of structured products. In recent years, it has brought a number of enforcement actions related to structured products with a focus on both sales practice and disclosure issues. The SEC's Enforcement Division has a special Complex Financial Instruments Unit, which includes former industry participants.

One example of an enforcement action involving the Complex Financial Instruments Unit concerned information about potential offerings (essentially, the embedded options from the investor's perspective) being shared between a structuring desk and potential issuers, but not included in internal education materials for financial advisers. The SEC found that the relevant supervisory policies and procedures were not reasonably designed and implemented to provide effective oversight of the training, education and recommendations of the registered representatives to prevent and detect violations of the Securities Act. This action has led market participants to focus even more heavily on whether, where information about structuring an offering (such as how the underlying reference asset is selected) is shared internally between business units or with issuers, that same information should be included in training materials prepared for financial advisers (and, potentially, shared with investors through the disclosure).

Other cases have concerned failures to adequately disclose hedging and embedded index fees that could negatively impact the value of an underlying index. These cases have further highlighted the importance of clear disclosure regarding trading strategies that underlie indices, as well as the importance of clear disclosure that sets out all of the costs and fees included in indices, including the effect of such costs and fees.

FINRA has also focused much of its recent attention on sales practice risks. Its 2021 Report on FINRA's Examination and Risk Monitoring Program, which is designed to inform member firms' compliance programmes by providing insights from FINRA's ongoing regulatory operations, highlighted communications, product recommendations and sales practice conduct (especially in the context of protecting senior and vulnerable investors), as well as disclosure for structured notes, as specific areas of focus.

The US regulators' focus on enforcement spans changes in administrations, and so is likely bipartisan.

vi The impact of international law and regulation

Outside of laws and regulations governing securities offerings generally, the main area where international developments have affected offerings of structured products in the United States has been in the sphere of benchmarks regulation. In 2013, the International Organization of Securities Commissions published its Principles for Financial Benchmarks: Final Report (the Principles), which seek 'to create an overarching framework of Principles for Benchmarks used in financial markets'8 covering governance and accountability, as well as the quality and transparency of benchmark design and methodologies. Under the Principles, the term benchmark is defined very broadly and includes, among other things, the types of indices often used as underlying reference assets for structured products. While the Principles are not binding, they have been highly influential. As a governance matter and in light of market expectations, many administrators of these types of indices (including proprietary indices) have undertaken audits and published public attestations or compliance statements disclosing the extent of their compliance with the Principles.

In relation to this, the EU Benchmarks Regulation (BMR) has established an EU regulatory framework for benchmarks, including requirements related to benchmark integrity and reliability, transparency and consumer protection, and the authorisation, registration and supervision of administrators. As is the case under the Principles, the term benchmark under the BMR is defined very broadly. In addition to imposing requirements on EU benchmark administrators, the BMR imposes requirements on third-country (i.e., non-EU) administrators by providing that, from January 2022, EU financial institutions will only be able to use a benchmark produced by a third-country administrator (such as a US administrator) in the EU if:

  1. the European Commission has adopted an equivalence decision recognising the regulatory framework in the applicable third country as equivalent to the requirements of the BMR;
  2. the third-country administrator is recognised under the BMR; or
  3. the benchmark has been endorsed by an EU financial institution.

As a result, US entities that create indices that will be used on a global basis (e.g., as an underlying reference asset for structured products soldlas to investors in the EU) have had to consider the requirements of the BMR in creating these indices, in addition to having to engage with regulators in the EU (e.g., in seeking recognition) so that these indices may be used beyond 2021.

vii Recent developments affecting underlying reference assets

Two recent regulatory developments have affected underlying reference assets, including the disclosure about such assets that issuers have provided for new issuances.

First, the Holding Foreign Companies Accountable Act (HFCAA) requires the SEC to identify each company that is required to file periodic reports with the SEC that has retained a registered public accounting firm that (1) is located in a foreign jurisdiction; and (2) the Public Company Accounting Oversight Board (PCAOB) is unable to inspect or investigate due to a position taken by an authority in the foreign jurisdiction. If the SEC determines that the PCAOB has been unable to inspect or investigate the accounting firm for three consecutive years, it will prohibit the covered company from trading its securities on a US securities exchange or in any 'over-the-counter' exchange in the US. The SEC will end a prohibition on trading if the covered company certifies to the SEC that it has retained a registered public accounting firm that the PCAOB has inspected to the satisfaction of the SEC. Some issuers have begun including disclosure in structured products linked to US-listed American depositary shares of China-based companies about potential delisting under the HFCAA.

Second, on 3 June 2021, President Biden signed Executive Order 14032, which refined and replaced President Trump's executive order concerning companies with ties to the Chinese military, with a delayed effective date of 2 August 2021 and a delayed divestment date of 3 June 2022. Executive Order 14032 prohibits US persons from engaging in the purchase or sale of any publicly traded securities (and derivatives) of certain companies with ties to the Chinese military. It does not prohibit US persons from possessing securities covered by the order following the conclusion of the 365-day divestment period, though any sale of these securities after that date would require authorisation from the Office of Foreign Assets Control. The definition of 'publicly traded securities' is broad and encompasses securities that trade 'over-the-counter', as well as on a securities exchange. Some issuers have begun including disclosure in structured products linked to Chinese underlying reference assets about these recent executive orders, as well as more generic disclosure about the potential impact of governmental regulatory actions, such as sanctions, in structured products linked to other non-US underlying reference assets.