The European Securities and Markets Authority (ESMA) finally published its views on the regulation of structured products on 7 February 2014, focusing in particular on selling practices relating to “complex” investments. Accepting that EU regulatory requirements in this area (as set out in the Markets in Financial Instruments Directive (MiFID1)) should already “be sufficient, if correctly applied, supervised and enforced,”2 ESMA felt it necessary to provide a detailed opinion (the “Opinion”)3 to national competent authorities (NCAs), serving as both a reminder of their existing duties and obligations when regulating the marketing and sale of complex products under MiFID, as well as providing additional color with respect to the approach that should be taken in order to ensure compliance. The existing approach under MiFID, it feels, is the right one. The execution, however, is lacking—particularly with respect to the conduct of business rules, such as information to clients, suitability and appropriateness. Accordingly, the intention is to find some “common ground where possible for distribution frameworks of complex structured products across the Union”.4
Alongside the Opinion, ESMA has also published a shorter document for the benefit of market participants, specifically addressing the risks of investing in complex products (the “Risk Warning”)5. The Risk Warning sets out (in limited detail), some of the principal risks that are inherent in investing in complex products (liquidity, leverage, market and credit risk), as well as details pertaining to the types of products that such investment risks apply. The principal features of both the Opinion and the Risk Warning are explored further below.
MiFID does not specify in detail precisely what constitutes a “complex product” (although it does define “non-complex” products)6. ESMA considers that everything that is not non-complex should be regarded as complex, and it has decided to set out some detailed examples of complex products and product types. Specifically, these include products that:
- are derivatives or contain embedded derivatives;
- are made up of one or more underlying financial instruments that are difficult to value or have been structured in a way that makes it difficult to assess the risks involved and the likely performance scenarios;
- incorporate opaque (i.e., non-market-standard) indices;
- effectively lock investors in for a fixed period (without adequately explaining the exit barriers);
- are subject to complex pay-off formulae (potentially including multiple variables); and/or
- contain conditional or partial capital protection rights (including where such rights can be withdrawn).
The Opinion further develops its definition, by listing some specific examples of products that it believes should be considered complex. These include, amongst others, contracts for differences, convertible or exchangeable bonds, warrants, certificates, certain types of derivatives, credit-linked notes and asset-backed securities. In fact, ESMA’s view is that “the vast majority of structured products” can be considered to be complex.
Organization and Controls
ESMA sets out a number of requirements in the Opinion relating to the internal controls and processes of firms when developing and selling complex products. NCAs are required to (among other things) monitor relevant internal controls (including any trading platforms that give access to complex products), ensure that firms do not offer advice with respect to products that are not in their client’s best interests, and ensure that relevant staff (including those establishing a product’s target market and assessing the needs and circumstances of clients) are adequately trained and have a detailed understanding of the workings and nature of relevant products and financial markets.
In addition to the above, ESMA requires that NCAs ensure that firms assess whether the complex product should be sold on an advised or non-advised basis to their target clients. Sales of complex products on a non-advised basis should be monitored to ensure that any categorization of clients is robust and correctly reflects the status of each client. Any such assessment should also take into account any identified conflicts of interest (which must be managed appropriately).
Suitability and Appropriateness
MiFID already requires that, when providing investment advice, firms obtain all necessary information with respect to a client’s knowledge and experience, financial situation and investment objectives, in order to recommend particular services or financial instruments which are suitable.7 However, in July 2012, ESMA published its “Guidelines on certain aspects of the suitability requirements,”8 which stated that investment firms should consider whether they require additional (more in-depth) information from clients when dealing with complex instruments. The Opinion further develops this requirement by providing that NCAs should monitor the additional information required, ensuring that it is sufficient for the purpose of establishing:
- the client’s objectives and attitude to risk (in particular, in relation to investments that involve leverage and those linked to highly volatile asset classes);
- any time horizons for the investment (taking a possible lack of liquidity into account);
- whether the client will have sufficient funds to cover reasonably foreseeable future commitments and comfortably afford possible losses (taking into account the amount of capital loss exposure);
- the client’s awareness of charges, risks and costs relating to a product and the way in which these variables might impact return; and
- the depth of a retail client’s knowledge and experience (this should include looking at prior transaction experience). Although this is already required under MiFID9, ESMA’s view is that firms should not over-rely on a client’s self-assessment and NCAs must ensure firms have policies and procedures in place to check that client information is accurate and up to date. This requirement applies with respect to tests for both suitability and appropriateness.
When assessing appropriateness, MiFID already requires that, where a firm determines that a product is not appropriate for a client, it must warn the client; and where the client does not provide sufficient information to assess his or her knowledge and experience, it requires the firm to warn the client that it will not be able to make an appropriateness determination. ESMA requires NCAs to carefully monitor the internal controls and processes of firms that have high numbers of clients that fall into this latter category.
ESMA is concerned about ensuring that all clients are fully aware of the total costs and charges applicable to each complex product. As a consequence, the Opinion requires that NCAs encourage firms to disclose cash values (even example ones), as well as the relative impact that charges may have on future performance. Firms should also disclose any potential consequences for seeking to sell or exit earlier than originally planned. This requires an explanation of how long clients need to hold their investment. In addition, clients should be made aware of circumstances where an early withdrawal may result in return of an amount less than the principal invested as a result of charges being applied.
The Opinion also gives guidance with respect to the application of MiFID’s “fair, clear and not misleading”10 principle:
- the realistic likelihood of receiving headline (maximum) returns should be clearly explained and not be the primary feature of any communication;
- jargon and technical terms should be avoided (such as “absolute” or “hedged”); and
- national investor compensation schemes (and whether they do or do not apply) should be highlighted.
In addition, product offerings for complex products should be very clear when setting out any details relating to capital protection (including the extent to which it applies). They should also highlight the impact of any leveraging or embedded derivatives and explain the functioning and legal effect of any product “wrappers”.
Monitoring and Execution
The Opinion provides some further guidance with respect to ongoing risk assessment by NCAs. ESMA’s view is that the greater the complexity of the product, the greater the scrutiny of the firm’s compliance function should be. Finally, ESMA also requires that a firm’s choice of execution venues (for the purchase and sale of complex products) and the application of its best execution policy be carefully monitored.
As referred to above, on 7 February 2014, ESMA also published a Risk Warning to complement the guidance provided in its Opinion. Unlike the latter document, which provides guidance to NDAs, the Risk Warning is intended to be reviewed by market participants who are considering investing in complex products. In summary, the Risk Warning:
- highlights certain “Key Messages,” including the need to understand the key features of the products being sold (and recommendation to obtain legal advice where necessary), to be aware of market terminology that may be misleading, to consider the ability to trade in and out of the product and to understand what the total costs are;
- defines “complex” products in a fashion similar to that set out in the Opinion;
- sets out certain key risks and disadvantages of investing in complex products—including liquidity risk (inability to sell the product, at least without incurring a significant loss, before the end of its term), leverage risk (the possibility that losses can be multiplied), market risk (complex products often expose an investor to one or more underlying markets) and credit risk (the inability of the product issuer to meet its contractual obligations should always be taken into account); and
- refers to the importance of being aware of product costs, which are often higher with respect to complex products (since investors are paying for the underlying features of the investment).
It is worth noting, however, that there is no requirement for the Risk Warning to be provided directly from issuers to potential investors. Its effectiveness, therefore, appears to be seriously limited, since it is not immediately obvious how ESMA or NCAs will ensure that the Risk Warning will be seen by the retail investors whom they are most focused on protecting.
Relationship with Other EU Initiatives
Although this is the first time that ESMA has published its views with respect to complex products generally (and not just suitability issues), its Opinion should also be viewed in the context of a host of similar initiatives at EU Member State, EU and global levels. The PRIPS initiative in the EU, for example, focuses heavily on the marketing and sale of certain investment products (those involving an indirect exposure to underlying assets) to retail investors. In some individual EU Member States, the complexity of certain investment products, among other things, dictates whether or not more stringent product regulations will apply. Other initiatives may also arise, perhaps on a more sectoral basis, as a result of recent harmonized European principles for the oversight of financial products development.11 As outlined above, ESMA’s
Opinion is directed specifically towards NCAs (not individual firms) and is intended only to assist and provide color with respect to ensuring compliance with MiFID as it already exists today.