The EU’s PRIIPs Regulation (Regulation (EU) No 1286/2014) (the “PRIIPs Regulation”), which came into effect on January 1 this year, has had a significant effect on practices in the wholesale capital markets. Many new practices seem to be of questionable necessity under a strict interpretation of the PRIIPs Regulation and have resulted in retail investors being restricted from straightforward bond issuances. The Association for Financial Markets in Europe (“AFME”) has recently written to the Commission to highlight the substantial reduction in the availability of non-structured bonds to retail investors in the EEA and urged the Commission to correct market failure by bringing issuers’ and advisers’ attention back to the text of the PRIIPs Regulation and the intention of the Level 1 legislature.
This client note discusses the implications of the EU PRIIPs Regulation for different types of capital market instruments and issuers and explains an alternative analysis that is more consistent with the likely intent of the Level 1 text, the existing framework for securities issuances under the Prospectus Directive and the Capital Markets Union. Under this alternative interpretation, PRIIPs should have no relevance to most vanilla bond issuances and is confined in its application to genuinely complex, packaged products which require special explanation to the retail market. We also consider the interaction between the PRIIPs Regulation and the exemptions under Directive 2003/71/EC (the “Prospectus Directive”) given its relevance to capital markets documentation.
Summary of PRIIPs Regulation
The PRIIPs Regulation applies to “packaged retail investment products” and “insurance-based investment products” (“PRIIPs”). A packaged retail investment product is defined as an investment where, regardless of its legal form, the amount repayable to a retail investor is subject to fluctuations, either because of exposure to reference values or because of the performance of one or more assets which are not directly purchased by the retail investor. The PRIIPs Regulation also applies to “insurance-based investment products.” However, these are unlikely to be relevant to capital markets transactions and are not discussed in this client note.
The PRIIPs Regulation and relevant Regulatory Technical Standards (“PRIIPs RTS”) introduce detailed obligations on PRIIP manufacturers (including issuers and potentially underwriters) and sellers (including underwriters and other downstream distributors of capital markets instruments). Key obligations are:
- Publication of a Key Information Document (“KID”). PRIIP manufacturers (any entity manufacturing a PRIIP or making changes to an existing PRIIP) must produce and publish a KID on their website before the PRIIP can be made available to retail investors. KIDs are three-page product summaries following a prescribed template containing, inter alia, a description of the nature and main features of the PRIIP, a summary risk indicator, potential maximum loss and performance scenarios. KIDs must be drawn up and so published in an official language of each member state in which a retail offering is made. The FCA has published a statement addressing industry concerns that the performance scenarios which are required to be included in KIDs could be misleading in certain circumstances.
- Provision of the KID in good time. PRIIP sellers (persons offering or concluding a PRIIP contract with a retail investor) must provide KIDs to the retail investor in “good time” before the retail investor is bound by any contract relating to that PRIIP.
Competent authorities of Member States have the power to impose regulatory fines, prohibit and suspend the marketing of a PRIIP and to prohibit non-compliant KIDs. In addition, the PRIIPs Regulation imposes civil liability on PRIIP manufacturers where a retail investor suffers losses as a result of reliance on a misleading, inaccurate or inconsistent KID.
Which Capital Markets Products Are In Scope?
A crucial question facing wholesale capital markets participants is whether the PRIIPs Regulation applies at all to the sector and, if so, which products are within scope. The PRIIPs Regulation operates by carving out certain products from its application but it does not expressly set out which products are within scope. Excluded products include deposits (other than structured deposits), non-equity securities issued by Member States, their local authorities, the ECB or Member State central banks, and securities unconditionally and irrevocably guaranteed by a Member State or by its regional or local authorities. Whether other products are PRIIPs needs to be considered according to the product’s detailed terms. We examine several types of capital markets instruments below.
Corporate Shares and Sovereign Bonds
Corporate shares and sovereign bonds are not PRIIPs. The U.K. Financial Conduct Authority (“FCA”) has commented that assets held in dematerialized form through nominee accounts are also unlikely to be in scope.
Warrants and Convertible Bonds
Warrants and convertible bonds have been seen by many as likely to fall within the scope of the PRIIPs Regulation because of the view that the amount repayable fluctuates due to exposure to an asset which the investor did not directly purchase. However, as set out in the “Repayable vs Payable” section below, an alternative reading is possible, depending on the terms of the instruments.
Fixed Rate Bonds
Fixed rate bonds which redeem at par and do not include a “make-whole” clause with a reference rate feature (see below) can generally be considered to fall outside the scope of the PRIIPs Regulation because the amount repayable to investors is not subject to fluctuation.
However, there are many who see bonds with “make-whole” clauses as PRIIPs. Such clauses apply if there has been an early redemption or prepayment (whether mandatory or at the issuer’s volition). These clauses typically require bondholders to be paid the principal amount of their investment and a sum reflecting the future interest payments that the bondholder had expected to be paid during the lifetime of the bond (usually discounted at an appropriate reference rate (e.g. a gilt rate). If the payment reflecting future expected cash flows is subject to fluctuation due to exposure to a reference rate, the bond could, in the eyes of some, potentially constitute a PRIIP. Industry uncertainty on this point has led to the risk-minimizing approach of designating bonds without completely fixed returns as not intended for retail, which has resulted in a substantial reduction in direct access to vanilla bonds for retail investors.
However on an alternative and reasonable interpretation of the PRIIPs Regulation discussed below, fixed rate bonds with investor protection features such as make-whole clauses would also be outside the scope of the PRIIPs Regulation. See “Repayable vs Payable” section below. Essentially, if the principal (i.e. the repayable amount) does not fluctuate, the bond should not be a PRIIP.
Floating Rate Bonds
The position of floating rate bonds is also one where many industry participants have taken a conservative view. Where the coupon is linked to a floating rate, the return to the investor is subject to fluctuations because of exposure to a reference rate. This would suggest to some that floating rate bonds are PRIIPs.
However, the FCA has stated that debentures should be assessed on a case-by-case basis and emphasizes that they will only be PRIIPs where “the amount repayable to the retail investor is subject to fluctuations…” The amount repayable under a floating rate note is generally fixed at the principal amount invested. This point is discussed in “Repayable vs Payable” below. In addition, deposits are specifically excluded from the scope of the PRIIPs Regulation (with the exception of structured deposits). From a policy perspective, it would be anomalous for a vanilla floating rate deposit with an interest rate linked to LIBOR or EURIBOR not to be a PRIIP, whilst a floating rate bond that redeems at par with a yield linked to the same interest rate would be a PRIIP. Note that this argument falls away for floating rate bonds with performance caps or whose return is linked in a non-linear way with an underlying interest rate, as deposits exhibiting these features are regarded by the European Supervisory Authorities (“ESAs”) as PRIIPs.
“Repayable” v “Payable”
For an investment to be a PRIIP, the amount “repayable” to the retail investor must be subject to fluctuation.
The use of the word “repayable” rather than “payable” can be interpreted as referring to an investment’s principal amount rather than any interest payments. Such an interpretation is plausible and would have a significant impact on the applicability of the PRIIPs Regulation as compared to the more conservative industry participant approaches discussed above. If this interpretation is correct, then all bonds where the capital amount is not subject to fluctuation are out of scope, including fixed rate bonds with make-whole clauses irrespective of fluctuating returns, and floating rate bonds with coupon exposure to reference rates. The PRIIPs Regulation would potentially only apply to securitized products and products with embedded derivatives where the principal amount is subject to fluctuation. Such an interpretation, particularly as it applies to bonds, is consistent with the exemptions in the Prospectus Directive and with the Capital Markets Union objectives to strengthen access to public markets. We believe that this is what was intended by those who legislated for PRIIPs. Regulatory guidance on this issue would be most welcome.
Some capital markets participants have questioned how the PRIIPs Regulation applies to legacy products, given that no grandfathering regime is set out in the PRIIPs Regulation.
The Commission’s Guidelines on the PRIIPs Regulation (“EC Guidelines”) clarify that where a PRIIP is no longer made available to retail investors as of January 1, 2018, a KID is not required. As such, closed-book products that cannot be obtained by any new retail investors from that date should be out of scope. KIDs are also not required where: (i) changes to investors’ existing commitments are only subject to contractual terms and conditions agreed before January 1, 2018; and (ii) contractual terms and conditions allow exiting the PRIIP, as long as the PRIIP is no longer made available to retail investors from 1 January 2018 onwards. Investors currently holding legacy PRIIPs for which no KID has yet been published could also be substantially affected, as such investors must now hold the instrument to maturity or are restricted to only selling legacy PRIIPs products to non-retail investors.
For running offers or program documentation effective on January 1, 2018, the position is less straightforward. While the EC Guidelines specifically state that PRIIPs made available to retail investors before January 1, 2018 that continue to be made available to retail investors after that date would be in scope of the PRIIPs Regulation, unresolved uncertainties surrounding the meaning of “made available” (see below) raise concerns about whether an instrument issued before January 1, 2018 was being “made available” by the issuer after that date due to retail investor participation in the secondary market (e.g. on-sales or on trading venues to which retail investors have direct access). It could be argued that the PRIIPs Regulation should be interpreted in line with the interpretative principle of non-retrospectivity of EU law (unless the purpose of the legislation clearly demands it and subject to legitimate expectations being protected), and therefore unless manufacturers take active steps to distribute legacy PRIIPs to retail investors they should not be subject to the PRIIPs Regulation for their legacy issuances.
In the absence of clear guidance, issuers, together with exchanges and financial intermediaries involved in secondary sales, should consider who has access to such legacy PRIIPs and consider: (i) whether and, if so, how selling restrictions should be imposed on access by a retail investor located in the EU (or, when the PRIIPs Regulation is eventually implemented into EEA law, the EEA) (“EEA retail investors”) in circumstances where no KID will be prepared by the issuer; and (ii) if EEA retail investor access is desired, publishing and distributing KIDs.
Meaning of Made Available
The obligation on PRIIP manufacturers to publish a KID applies where a PRIIP is being “made available” to an EEA retail investor.
There is little guidance as to the meaning of “made available.” The EC Guidelines state that access by EEA retail investors to a website of a person advising on or selling a PRIIP should not mean that the PRIIP has been “made available” to those investors and therefore trigger an obligation to produce a locally translated KID. Similar reasoning may also apply to interpreting when a PRIIP will be deemed to have been generally “made available” to EEA retail investors and a more active distribution might be necessary to trigger the PRIIPs Regulation. Further regulatory guidance would be welcome.
Ambiguity on the meaning of “made available” has also raised concerns that in circumstances where no KID has been prepared, downstream intermediaries with no contractual connection to an issuer could on-sell to an EEA retail investor. EEA retail investors may also have direct access (or indirect access facilitated by their broker) to an EEA or third-country exchange on which the instrument is listed. In such situations it is unclear whether the issuer or underwriter would be held to have made the instrument available to EEA retail investors. This has resulted in PRIIPs-specific selling restrictions being included in offering documents and the rulebooks of several exchanges to restrict EEA retail investor participation.
Exemptions From the Prospectus Directive
Issuers and underwriters have also raised questions on the interaction between capital markets instruments subject to the PRIIPs Regulation and commonly used exemptions in the Prospectus Directive from the requirement to publish an approved prospectus for public offers of securities (e.g. offers to qualified investors, offers to fewer than 150 natural or legal persons per member state, offers where the minimum denomination is at least EUR 100,000), and how this should be reflected in the legends and selling restrictions included in offering documents.
Broadly, where an issuer does not wish to produce a KID for a PRIIP but does wish to rely on the exemptions from the full application of the Prospectus Directive, both PRIIP selling restrictions and Prospectus Directive exemption legends should be included in the offering documents.
By way of example, an issuer relying on the qualified investor exemption from the Prospectus Directive will also need to include PRIIPs selling restrictions if it does not intend to produce a KID, as directing an offering solely to “qualified investors” will not necessarily restrict retail investors. This is because the definition of “qualified investor” could potentially include customers under Directive 2002/92/EC (“IMD”) who are included in the definition of “retail investors” under the PRIIPs Regulation and defined differently to the retail category under the Prospectus Directive.
An ICMA working group has developed pro forma legends and selling restrictions for use in capital markets transactions, which aim to address both the PRIIPs Regulation restrictions and the Prospectus Directive qualified investor exemption in the same legend and selling restriction. As for the other Prospectus Directive exemptions from the requirement to publish a prospectus, issuances of PRIIPs to investors under those exemptions must still include a PRIIPs no “retail investor” restriction to avoid risks of the issuer being required to produce a KID.
The Prospectus Directive is due to be replaced by a new Prospectus Regulation (various provisions of which started becoming effective from July 20, 2017). The Prospectus Regulation preserves the qualified investor, 150 persons and EUR 100,000 minimum denomination exemptions already familiar to capital markets participants. From July 21, 2019, the Prospectus Regulation establishes a category of shortened “wholesale” prospectuses for non-equity securities traded on a regulated market (or segment of a regulated market) to which qualified investors only have access. Non-equity securities, which are listed on such a “qualified investor” only segment or market, would still need PRIIPs restrictions due to the technical inconsistencies between the PRIIPs retail investor definition and the definition of a qualified investor. The Prospectus Regulation also allows for the prospectus summary requirement (applicable for admissions to trading on a regulated market) to be substituted by the KID that has been produced by the issuer for the PRIIP that is the subject of the offering. Member States are also allowed to require that, where they are the home Member State approving a prospectus for a retail offering, the prospectus summary be substituted by the KID produced by the issuer for the PRIIP which is the subject of the offering instead.
The uncertainties of the application of the PRIIPs Regulation to capital markets instruments have meant that many capital markets industry participants have conservatively included PRIIPs-specific selling restrictions in addition to Prospectus Directive selling restrictions. However, an alternative reading is possible which would confine PRIIPs to products which truly need retail explanation, rather than simple bond issuances where producing a KID to explain what LIBOR or a fixed percentage means in multiple languages, for instance, would seem unnecessarily burdensome.
The PRIIPs Regulation’s scoping issues are further exacerbated by the lack of clarity as to when a product will be taken to have been “made available” in the EEA.
Separately, the PRIIPs Regulation has substantially limited the utility of the exempt offers regime under the Prospectus Directive, as offers exempt from the requirement to publish a prospectus are not necessarily excluded from the requirement to produce a KID under the PRIIPs Regulation, unless additional PRIIPs-specific selling restrictions are included (which could cut off investors to whom the issuer may have wished to offer instruments under the Prospective Directive’s exemptions). Although KIDs are shorter, they raise risks given the lack of space to include standard risk disclosures and are often more expensive to produce given the language translation requirements.
The PRIIPs Regulation’s difficulties have also carried over into the secondary markets, as it may, for example, be unclear as to whether legacy PRIIPs products can continue to be accessed by EEA retail investors (assuming no KID has been published by the manufacturer). These outcomes seem to run contrary to the EU’s “capital markets union” proposals and are likely to be unintended consequences of widely-drafted legislation. The uncertainties highlighted here should be clarified by the regulators, for example in the Commission’s review of the PRIIPs Regulation which is due to be completed by December 31, 2018.