United States: EU Prospectus Directive Update

The Prospectus Directive (the "Directive") is due to be implemented by EU Member States on 1 July 2005 and will be applied throughout the EEA¹. It is being implemented in the UK by the revision of Part VI of the Financial Services and Markets Act 2000 and the FSA Rules. This memorandum highlights issues and possible solutions for issuers, especially non-EEA issuers. Many of these were initially discussed in our memoranda published in October 2004 and March 2004. We have purposefully deferred preparing a further memorandum until it has been possible to suggest clear solutions to a number of previously highlighted issues.

This briefing is not intended to, and does not, constitute legal advice. The implications of the Directive will be different for each issuer depending on its particular circumstances. Any reader interested in the implications of the Directive on their activities should contact their legal advisers.

The Directive sets out the new requirements for content and approval of a prospectus applicable to offers of securities and the admission of securities to trading on regulated markets, such as the London Stock Exchange,² throughout the EEA.

The principal achievement of the Directive is that a prospectus approved by the regulatory authority of one EEA state can be passported enabling the issuer to make retail offers throughout the EEA without requiring further approvals from local regulatory authorities.

Issuers need urgently to make decisions, such as whether to issue to the wholesale or retail market, how to avoid giving investors a right to cancel a purchase of securities and about the form a prospectus may take. Issuers who wish to continue to issue securities on a regulated market after 1 July 2005 will be required to submit updated documents, which are compliant with the Directive, to their relevant regulatory authority for approval. Issuers should consider whether it is appropriate to approach regulators with their updated documents because many outstanding regulatory uncertainties have now been clarified (though some remain to be clarified by 1 July 2005).

Whilst some issuers are likely to find the additional disclosure requirements of the Directive relatively easy to satisfy because they will already be preparing their financial statements in accordance with International Financial Reporting Standards ("IFRS") or domestic accounting standards which are deemed equivalent and their annual reports will contain much of the additional information required under the Directive regime, they will have various strategic decisions to make and implement before 1 July 2005.

The FSA has recently put out a press release stating that it is currently inappropriate for it to publish a policy statement or near final rules in relation to the implementation of the Directive and hoped that near final rules can be published towards the end of May.

Directive-compliant prospectuses can be drawn up as a single prospectus consisting of a "registration document" (containing corporate details and information about the issuer), a "securities note" (containing information about the securities offered to the public or to be admitted to trading on a regulated market) and a "summary note" (giving an overview of the essential characteristics and risks associated with the issuer and the securities).

For MTN programmes covering plain vanilla issues, a "base prospectus" is required (which contains the same elements described above about the issuer and the securities in one document), and a pricing supplement termed "final terms" is used for each issue. The advantage of this arrangement is that only the base prospectus, and not the final terms, needs to be approved by the regulator, allowing immediate issues off the programme using final terms without additional approval.

However, final terms cannot be used for more complicated transactions where it is necessary to do more than simply complete dates and pricing. This is because the Directive requires that every "significant new factor" relating to information included in the prospectus which could affect the assessment of the securities, and which occurs from when the prospectus is approved to the final closing of the offer,must be included in a "prospectus supplement". Final terms can only include information that is required by the relevant securities note annex to the Regulation (as defined below). Therefore, any material changes or material additions to the proforma terms and conditions contained in the base prospectus necessary for an issue will require a prospectus supplement. In particular, for US issuers, such material developments will generally include each Form 10-Q, but may also include Forms 8-K. US issuers will need to establish a process whereby the base prospectus and registration document are supplemented for each Form 10-Q and those Forms 8-K that are considered material.

If a prospectus supplement is required, investors have a right to cancel their purchases for two working days from the date of publication of the prospectus supplement.

For MTN programmes, the UK Listing Authority (the "UKLA") has indicated that, it will accept a separate "registration document" produced by issuers, to be read alongside the base prospectus. Using this approach, the registration document would be approved by the UKLA and a proforma securities note would be approved in principle. The registration document would incorporate by reference that part of the base prospectus which contains the information required by the relevant annex to the Regulations (as defined below). Instead of issuing notes under a base prospectus, which could trigger the requirement to produce a prospectus supplement, the securities would be issued under the registration document. On drawdown, the issuer could issue a securities note which, together with the registration document (both of which would be formally approved by the UKLA), could constitute the prospectus. The securities note would incorporate by reference information contained in the base prospectus and set out, in similar form to a pricing supplement, the information for the specific issue. As a securities note is not a prospectus supplement, the cancellation right would not be triggered.

The Financial Services Authority (the "FSA") is currently carrying out a consultation on establishing who has the responsibility for producing prospectuses. The key proposals are to retain the requirement for issuers and their directors to take responsibility for equity share prospectuses, and to require issuers to take responsibility for prospectuses for other securities (including retail and wholesale debt and convertible and exchangeable securities). This reflects the current requirements and the FSA has indicated that it considers that this represents a sensible balance between investor protection and maintaining the competitiveness of the UK market. It is hoped that, after consultation, non-equity securities prospectuses (whether retail or wholesale) will only be required to include an issuer’s responsibility statement. The deadline for responses on this proposal is 27 May 2005.

Regardless of which form of prospectus is used, the contents are determined by the information provided in the annexes to Commission Regulation 809/2004 (adopted in connection with the Directive) (the "Regulation"), and differ depending on the nature of the issuer, the nature of the securities, whether the minimum denomination of the securities is at least €50,000 and any applicable credit support. The Regulation will be implemented in the UK on 1 July 2005 by the Prospectus Rules, which will reproduce the annexes to the Regulation.

To permit the wholesale Eurobond market to operate and enable activities such as underwriting to take place, a Directive-compliant prospectus is not required when offers are made only to "qualified investors" (Article 2.1(e) of the Directive), such as credit institutions, investment firms, governments and certain "small or medium size enterprises" ("SMEs"), or the securities are "non-equity securities" with a minimum denomination of at least €50,000 ("wholesale debt"), unless the securities are to be admitted to trading on a regulated market. Where wholesale debt is to be admitted to trading on a regulated market, the requirements are less onerous than for the retail market.

However, it will not be possible to access retail investors generally if sales are made relying on the qualified investor exemption because it only extends to SMEs (and certain individuals) in an EEA state if that state has elected to establish a register of such investors. Even if an EEA state does so (e.g. the UK will), the class of individuals is very limited and there are not likely to be many applicants who would wish to apply for individual "qualified investor" status because their inclusion on the register will be an indication of their relative wealth.

Denominations of less than €50,000 may be attractive to institutional investors as they enable them to make small adjustments to the investment spread in their portfolios to get the appropriate weighting. It is also easier for them to trade securities of smaller denominations on the secondary market. The issue of securities with low denominations may be attractive to some issuers based on their investor market, despite the more onerous Directive requirements and the greater risk that an issuer could face litigation under the Directive.

The new passporting regime under the Directive allows sales by an issuer to retail investors throughout the EEA (after initial approval of the prospectus by the regulatory authority of one EEA state) by the approving regulatory authority simply notifying the competent authority of each of the relevant EEA states of such proposed sales. The only constraint is that an issuer may be required to translate the summary section of its prospectus into the national language of the relevant EEA state, or the whole prospectus if it is not in a language used in international finance, such as English. This translation requirement may lead to issuers limiting retail sales to those jurisdictions that do not require a translation from English or where the cost of translation is likely to be justified by additional sales.

The most significant concern that issuers need to consider is the increased risk of litigation where a prospectus is used for retail sales. Civil and criminal liability for breaches of the provisions implementing the Directive’s requirements are decided by each EEA state and an issuer could potentially be sued for an alleged breach of the Directive in each state where its securities are offered or sold. This means that issuing to retail investors could greatly heighten the risk to issuers. Where the minimum denomination of the securities is €50,000 or more, no prospectus is required under the Directive for sales in an EEA state unless there is admission of the securities to trading on a regulated market in that state. Therefore, in the case of minimum denominations of €50,000 or more, the issuer should, in theory, only be capable of being sued for failure to comply with the Directive in the EEA state where the prospectus is originally approved for any such admission. As a result, issuers may wish to consider whether the pricing advantages for a retail issue outweigh the increased risks of litigation.

There will be some changes to the format of prospectuses because of the new requirement that the prospectus for a straight debt issue to investors contain two years of IFRS or equivalent accounts. However, the Directive expressly permits the incorporation by reference of documents previously filed with the same regulator, so it will be possible to satisfy this, and many of the other new requirements (examples include details about the board practices or interim accounts in the case of retail issues) by incorporating information from the issuer’s annual report and accounts. Information may not, however, be incorporated by reference in the summary section of a prospectus. Care will be needed when doing this as the information to be incorporated by reference will need to have been prepared to prospectus standards of due diligence. As not all the information in such incorporated documents may satisfy this demanding requirement, it may be necessary to be specific about what information is being incorporated by reference or to reproduce the information in full in the prospectus. The second approach would, of course, be more helpful to prospective investors, but will increase printing costs.

A potentially serious threshold issue for issuers who do not benefit from transitional relief, (in the case of EEA issuers, by virtue of having securities admitted to trading on a regulated market on 1 July 2005; or in the case of non-EEA issuers, by virtue of having their securities admitted to trading on a regulated market on 1 January 2007 and who have prepared their accounts to local standards (subject to them giving a true and fair view)) is the requirement in the annexes to the Regulation that "the most recent year’s historical financial information must be presented and prepared in a form consistent with that which will be adopted in the issuer’s next published annual financial statements having regard to accounting standards and policies and legislation applicable to such annual financial statements."

For example, if the accounting treatment for an issuer’s accounts in respect of 2005 will be different from that with respect to 2004 because of changes to IFRS or a change from national accounting standards to IFRS and the 2004 accounts are included in the prospectus, the 2004 accounts will have to be adjusted to conform to the new basis. This has the effect of bringing forward the need for this adjustment as the 2004 accounts included with the 2005 accounts would in any event have to be on a basis consistent with the 2005 accounts. However, making this adjustment in time for the prospectus may be problematic if this requirement has not been anticipated.

As discussed in more detail in our previous memoranda, by 31 December 2005, a non-EU issuer has to notify the regulator in an eligible state that the issuer has selected that state to be its "home Member State". The issues and uncertainties we have previously identified surrounding this area have been increased by certain comments which we understand were made by the European Commission. Clients should contact us for specific advice with respect to their individual circumstances.

The listing approvals for an MTN programme normally run for 12 months. MTN issuers should have been contacted by their dealers already regarding the need to have their prospectuses re-issued under the new Directive requirements and further approved on or after 1 July 2005 in order for them to continue to access the regulated markets. Issuers needing to update their programmes prior to 1 July 2005 because their current approval has expired may, from now, submit their prospectuses to the UKLA for approval as "listing particulars" which are prepared only in accordance with the Directive requirements. This allows an issuer to use a Directivecompliant prospectus before and after 1 July 2005 and avoids the need for an issuer to update its programme in accordance both with the current UKLA Listing Rules and the Directive. Of particular significance is the fact that capitalisation tables will no longer be required in a document for "stamp-off " purposes before the 1 July 2005 effective date, although the UKLA has indicated that a letter requesting derogation from the current requirements should be submitted. Other regulators are also accepting prospectuses and MTN documents from issuers for review in anticipation of the 1 July 2005 effective date.

Although the UKLA has indicated that it will be able to give an informal indication whether a document will meet the new requirements under the Directive, the prospectus must still be formally re-approved on or after 1 July 2005. An issuer must then either confirm that, as at the date of re-submission, there have been no material changes or litigation, or include additional information to make sure the prospectus is completely up-to-date and accurate. As at the date of this memorandum, regulators have expressed no preference as to what form this update may take. In order for the UKLA to "stamp off " documents that have been informally preapproved on or after 1 July 2005, it is necessary for an issuer to submit a re-dated prospectus which is either a blacklined version that highlights the additional changes from when the document was informally approved or has a "wrap" around it containing the additional information that has been added since its informal approval, together with a letter from the issuer stating that the document is accurate as at the date it is to be "stamped-off ". Issuers are also likely to be asked to obtain an auditor’s comfort letter with respect to the additional update.

It is hard to predict how long the review process will take in any given case, but at the date of this memorandum, the UKLA is working towards a 5 day turnaround on initial submissions. However, clients should expect a three to four week review and comment period to complete the update process. The UKLA has requested that the majority of MTN programmes are not renewed on or around the 1 July 2005 effective date to help maintain their turnaround times for the review process.

The UKLA has indicated it will charge, for any expired MTN programmes, the normal vetting and application fee for the first time a document is approved under the current UKLA Listing Rules. When the document is then re-submitted for approval under the Directive requirements, if the programme expired on its original expiry date (i.e. one year from the date it was approved under the current UKLA Listing Rules), then it will not charge a fee for approving it under the Directive requirements. If the issuer changes the document expiry to July 2006 on re-submission for approval under the Directive requirements, then a vetting fee and application fee will be charged.

In contrast to the UKLA’s approach, the Luxembourg listing authority is allowing issuers to extend the life of their MTN programmes to permit drawdowns off programmes which would otherwise have expired before 1 July 2005, without the need for updating until they are able to submit a Directivecompliant prospectus. The Luxembourg listing authority is currently working towards a 10 day turnaround on initial submissions of prospectuses and clients should expect a four week review and comment period to complete the update process.

The difficulties previously highlighted in respect of the Transparency Directive for non-EU issuers that do not produce audited accounts to IFRS (or equivalent) or whose financial statements, even with supplemental information, are not deemed to give a true and fair view of an issuer’s financial position, remain of concern. In particular,we suggest that such issuers who are proposing to issue securities in denominations of less than €50,000 consult their auditors at an early stage to consider whether a restatement of their financial statements will be necessary if the Transparency Directive is applicable.

On 27 April 2005, the Commission of European Securities Regulators ("CESR") issued their draft technical advice stating that Canadian, Japanese and US GAAP, taken as a whole, is equivalent to IFRS, subject to a number of points, including some additional reporting and, in respect of certain IFRS standards, additional descriptive or quantitative disclosures (such as producing under local GAAP proforma balance sheets and profit and loss accounts which include any subsidiaries such as special purpose entities which would be consolidated under IFRS but would not be consolidated under local GAAP).

The UK is currently in the process of establishing a listed, but unregulated market in EU regulatory terms, which is likely to be known as the "Professional Securities Market" (the "PSM"). A similar approach is being taken in Luxembourg and Ireland. Its establishment is designed to allow issuers who do not wish, or are not able, to comply with the Directive’s requirement for financial statements to be prepared in accordance with IFRS or an equivalent standard (or the Transparency Directive’s similar requirement in the future), to continue to issue and list their securities in the UK. This is because the Directive will not be applicable to the listing and admission of securities to trading on such market. However, the securities can only be marketed and sold under an exemption from the Directive, such as that for sales to qualified investors. Therefore, a general marketing to individuals of the securities will not be possible. Furthermore, it remains unclear whether institutional investors will be subject to any internal restrictions which prevent them from investing in securities only admitted to such a market or which limit such investments, despite various surveys of investors by the International Primary Market Association.

The UK and Ireland currently intend that the content requirements of a prospectus for the PSM will be broadly the same as for a wholesale prospectus under the Directive. A corporate responsibility statement will be required. However, the UKLA has indicated that it is intending to carve sovereigns out of the responsibility statement requirements, though this will require certain further amendments to the current rules which the UK Treasury still need to iron out. Luxembourg, by contrast, will not be applying the Directive to its PSM but will instead apply its current listing regime.

The PSM’s most important value for issuers preparing financial statements in accordance with IFRS appears to be in providing a safety net if they are unable to have a Directive EU compliant prospectus in place on 1 July 2005. Issuers who do not update their prospectuses to be Directive-compliant once the Directive comes into force will automatically be able to use their programmes on the PSM. However, as discussed above it remains to be seen whether institutional investors will be able to, or would want to, invest in securities listed on the PSM.

It is clear that issuers will need to make a few key decisions between now and 1 July 2005. The regulators have been very helpful during this transitional period and many of the previous uncertainties have now been clarified. There is no reason to believe that issuers will be out of the market after 1 July 2005 because of these changes, provided action is taken quickly.