Worldwide: Structured Thoughts: News For The Financial Services Community, Volume 6, Issue 9

ESMA Final Report on Complex Debt Instruments and Structured Deposits 

On 26 November 2015, the European Securities and Markets Authority ("ESMA") published its Final Report on its "Guidelines on complex debt instruments and structured deposits". The Final Report follows ESMA's Consultation Paper on the same issue published in March 2015 on which we previously reported1.

Background and Initial Consultation

The Consultation Paper is focused on the "execution-only exemption" contained within the Markets in Financial Instruments Directive ("MiFID") and the amendments to such exemption made pursuant to a recast MiFID Directive now expected to come into force from January 2018 ("MiFID II"). This exemption relates to the level of diligence that firms are required to carry out on their clients before providing financial services to such clients. Where an execution-only service relates to non-complex financial instruments specified in Article 19(6) of the existing MiFID and certain other conditions apply, the investment firm can provide the service to the client without having to carry out either suitability or an appropriateness assessment in relation to such client. The Article 19(6) list of instruments includes bonds and similar debt instruments admitted to trading on a regulated market or equivalent third country market but specifically excludes any such bond or other instrument that embeds a derivative.

Article 19(6) of MiFID will be replaced by Article 25(4) of MiFID II when it comes into force. In addition to the exclusion of debt and other instruments embedding derivatives, the exemption will also exclude (i) bonds or other securitised debt incorporating a structure which makes it difficult for the client to understand the risk involved and (ii) structured deposits which incorporate a structure which makes it difficult for the client to understand the risk of return or the cost of exiting the product before its term. ESMA is required under MiFID II to develop technical standards by 3 January 2016 as to how these additional provisions should be assessed.

Final Report

In its Final Report, ESMA notes that it received 32 responses to the Consultation Paper. Following this feedback, ESMA states that it has made some modifications to the Guidelines set out in the Consultation Paper and provided further analysis in relation to what it regards as an embedded derivative.

A key element of ESMA's previous Consultation Paper was its non-exhaustive list of debt instruments which it would generally regard as embedding a derivative or incorporating a structure, making it difficult for the client to understand the risk involved and, in each case, therefore not being capable of falling within the execution-only exemption. In the Final Report, these examples have now been moved into a table within the Guidelines themselves.

Instruments Embedding a Derivative

In relation to the examples of instruments that ESMA regards as embedding a derivative, the only change to the previous Consultation Paper is the deletion of inflation-indexed bonds. Following the responses to the Consultation Paper, ESMA acknowledges that such bonds are widely used by retail investors as a hedge against inflation, and the average retail investor normally understands the mechanism involved. ESMA states that it accepts the argument that the link between the coupon or principal payment and the inflation rate should not be regarded as an embedded derivative within the meaning of the guidelines, and such products should not, therefore, be regarded as complex. Convertible/exchangeable bonds, indexed bonds and turbo certificates, contingent convertible bonds, callable/puttable bonds, credit-linked notes and warrants all remain within the list of examples of debt instruments embedding a derivative.

Instruments Incorporating a Structure Making it Difficult for the Client to Understand the Risk

In relation to instruments that incorporate a structure making it difficult for the client to understand the risk, ESMA has deleted the general definition contained in the Consultation Paper stating that this should be interpreted as meaning "a structure and the related risks that an average retail client would be unlikely to readily understand" following feedback in the consultation that this general reference was not helpful in practice. In its list of examples of products that would normally be regarded as coming within this category, very few changes have been made by ESMA, but the following points should be noted:

  • The examples now include a specific reference to debt instruments with complex mechanisms to determine or calculate the return. It is stated that this category includes debt instruments structured in such a way that the anticipated revenue stream may vary frequently and/or markedly at different points of time over the duration of the instrument either because certain pre-determined threshold conditions are met or because certain time points are reached.
  • ESMA has accepted that the fact a debt instrument is denominated in a non-domestic currency should not automatically make the instrument complex and should not, therefore, be regarded as coming within its categorisation of debt instruments with an unfamiliar or unusual underlying.
  • ESMA has deleted the specific reference to instruments that would be regarded as packaged products under the PRIIPs Regulation on the basis that such products will almost certainly be deemed complex under one of the other categorisations.
  • In relation to debt instruments issued by SPVs, a slight change has been made to state that this applies in circumstances in which the name of the debt instrument or legal name of the SPV may mislead investors as to the identity of the issuer or guarantor.

In relation to the list of criteria that would result in a structured deposit incorporating a structure making it difficult for the client to understand the risk of return, ESMA has added the situation where the contract gives the credit institution the unilateral right to terminate the agreement before maturity.

Examples of Non-Complex Products

In addition to examples of debt instruments that would generally be regarded as complex, the Consultation Paper also included a list of debt instruments that would be generally regarded as non-complex by reference to the relevant criteria, although this was a short list comprising of step-up notes (providing for an increasing rate of interest over time according to a predefined schedule), floating rate notes and covered bonds. The Final Report includes an additional list of instruments that it would not regard as embedding a derivative or incorporating a structure which makes it difficult to understand the risk, including:

  • inflation-linked notes;
  • debt instruments denominated in a currency different from the one of the jurisdiction where the investment services are provided; and
  • structured deposits where the return is linked to a currency which is not the one of the jurisdiction where the structured deposit is offered.

ESMA also states that it accepts the argument that a tax clause feature (allowing the issuer to redeem an instrument in the case of future changes to tax law that would require it to make additional payments) is relatively simple and should not make an instrument complex for the purpose of the Guidelines.

Next Steps

ESMA now regards the Guidelines as final and states that they will now be translated into the official EU languages and published on ESMA's website. The publication of the translations will trigger a two-month period during which national competent authorities must notify ESMA whether they comply or intend to comply with the Guidelines.

PRIIPs – Latest Consultation Paper from the ESAs

On November 11, 2015, a Joint Consultation Paper2 in relation to PRIIPs Key Information Documents was published by the European Banking Authority ("EBA"), the European Securities and Markets Authority ("ESMA") and the European Insurance and Occupational Pensions Authority ("EIOPA", and together, the "ESAs"). The paper sets out draft regulatory technical standards ("RTS") with regard to presentation, review and provision of the Key Information Document ("KID") required to be provided in respect of packaged retail investment and insurance-based products ("PRIIPs") pursuant to the EU Regulation in relation to PRIIPS (the "PRIIPS Regulation)3, which came into force on 29 December 2014. The Consultation Paper includes proposals in relation to the methodologies underpinning the presentation of the risk reward profile and costs information required to be contained in the KID. The obligation on product manufacturers to prepare a KID will commence from the beginning of 2017.

The Consultation follows a joint discussion paper published by the ESAs in relation to the presentation and content of the KID published in November 2014 and a technical discussion paper on the same issues published by the ESAs on 23 June 20154.

Proposals in Relation to the Presentation and Content of the KID

The draft RTS provides a mandatory template to be used for each KID (including mandatory text). Certain permitted adaptations to the template are also provided. Amongst the major issues dealt with in relation to presentation and content are:

Risk indicators:

The draft RTS requires a summary risk indicator ranking the PRIIP on a numerical scale from 1 (lowest risk class) to 7 (highest risk class). The draft RTS contain a methodology for the assignment to each PRIIP of the relevant risk class, the inclusion of narrative explanations and, for certain PRIIPs, additional warnings.

The criteria for establishing the relevant risk class is set out in Annex II to the draft RTS. The criteria primarily comprise credit risk and market risk. In addition, for products that can be traded over the life of the product but for which no regulated liquid market exists, a warning shall be included under the risk indicator that selling the PRIIP before the recommended holding period may not be possible and may give rise to significant costs or losses. Where a product is denominated in a currency other than the legal tender in the member state in which it is being marketed, a narrative must be included stating that the return the investor gets may be higher or lower as a result of currency fluctuations.

Performance scenarios:

The draft RTS set out requirements for performance scenarios which are to be defined for the recommended holding period and for certain holding periods in between. The KID is required to include three performance scenarios: an unfavourable scenario, a moderate scenario and a favourable scenario. Annex IV to the RTS sets out the criteria to be used in relation to each scenario. Annex V sets out how the performance scenarios are to be presented, which also includes a template for the narrative to go under the performance scenarios. For insurance-based products, an additional performance scenario must be included reflecting the return the retail investor receives if a covered insurance event occurs.

Costs:

The draft RTS set out various requirements in relation to the presentation of costs. These require the inclusion of two tables – one entitled "Costs over time" and the other entitled "Composition of costs". The format of these tables is set out in Annex VII to the RTS.

In the "Costs over time" table, a single figure must be shown as the summary cost indicator of the total aggregated costs of the PRIIP. The methodology for the calculation is set out in Annex VI to the RTS. The figure is required to be expressed in both monetary and percentage terms. If relevant, a narrative must also be included stating that the table takes into account exit penalties. The table must also include a breakdown of one-off costs, recurring costs and incidental costs, all in accordance with methodology specified in Annex VI to the RTS. It must also include an aggregated figure of total costs and a percentage reduction in yield ("RIY") figure showing the impact of total costs on investor returns.

The "Composition of costs" table must include a narrative explanation of each of the costs specified and must state that the costs presented in the KID may differ from the actual costs the retail investor would pay, including where additional costs may arise where the investor chooses options throughout the life of the investment.

Revision of the KID

The draft RTS set out requirements for revision of the KID by the PRIIP manufacturer. The KID must be reviewed at least every 12 months. As part of the review, the PRIIP manufacturer must verify whether the information contained in the KID continues to be accurate, fair, clear and not misleading, and remains consistent with the content requirements of the KID under the PRIIPs regulation. The PRIIP manufacturer must also conduct an ad hoc review of the KID if it becomes aware of any change that affects or is likely to affect the information contained in the KID. In each case, the PRIIP manufacturer must revise the KID, as appropriate, following such review and that revision must include all information in the KID that needs to be updated so that the KID is up-to-date as a whole.

Timing of Publication of the KID

The draft RTS state that the person advising on or selling the PRIIP will be considered to have provided the KID in "good time" (as required by the PRIIPs Regulation) where they have provided the document sufficiently early for the retail investor to read and consider the document before being bound by any contract or offer relating to the PRIIP. In determining how long the investor needs in this regard, the person advising or selling the PRIIP must take into account, as appropriate: (a) the knowledge and experience of the retail investor with the PRIIP (or a similar PRIIP), (b) the complexity of the PRIIP and (c) the urgency for the retail investor of concluding the proposed contract or offer.

Consultation Questions

The Consultation Paper also sets out various questions where the ESAs seek specific feedback from stakeholders. These include whether the ESAs should clarify further the criteria for the comprehension alert required under the PRIIPs Regulation, whether PRIIPs manufacturers can voluntarily increase the specified risk indicator (this is not currently permitted under the draft RTS), whether the look-through approach in relation to the assessment of credit risk for a PRIIP packaged into another PRIIP is appropriate and whether the presentation of performance scenarios would be better in a graph than a table (or should be presented in both a graph and a table). There are also questions relating to the methodology used for the calculation of transaction costs.

Next Steps

The Consultation is open for response until 29 January 2016. The ESAs state that the final RTS, including feedback on the Consultation Paper, will be submitted to the EU Commission for endorsement by 31 March 2016. PRIIPs manufacturers must prepare and publish a KID for each PRIIP they manufacture for sale to retail investors from 1 January 2017, and, from such date, those selling or advising on PRIIPs must provide a KID to retail investors.

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Footnotes

1 See "Difficulty in Understanding? ESMA Consultation Paper on Complex Debt Instruments and Structured Deposits". http://www.mofo.com/~/media/Files/ClientAlert/2015/03/150327ESMAConsultationPaper.pdf

2 http://www.esma.europa.eu/system/files/jc_2015_073_cp_priips_key_information_documentsb.pdf

3 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=OJ:JOL_2014_352_R_0001&from=EN

4 http://www.mofo.com/~/media/Files/Newsletter/2015/08/150831StructuredThoughts.pdf

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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Authors
Bradley Berman
Jeremy C. Jennings-Mares
Peter Green
Anna Pinedo
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