The U.K. Financial Conduct Authority has published proposals1 to amend the scope of the rules governing packaged retail and insurance-based investment products (or "PRIIPs"). The FCA's proposals are designed to bring legal certainty to the scope of the PRIIPs regime, as it applies to corporate bonds. The consultation also addresses issues of misleading performance scenarios and summary risk indicators, and concerns about the transaction costs calculation methodology. It is hoped that the amendments will promote liquidity and improve choice in the retail corporate bond market and also reduce the complexity of key information documents (or "KIDs"), the information disclosure documents that must accompany PRIIPs when they are made available to retail investors.
The U.K. PRIIPs regime is based on the EU PRIIPs Regulation2 and the EU PRIIPs Regulatory Technical Standards,3 which the U.K. on-shored with minor amendments following its exit from the European Union. The main U.K. legislation is the on-shored version U.K. PRIIPs Regulation4 and the Technical Standards ("U.K. PRIIPs TS"). 5 The U.K. Financial Services Act 20216 made some amendments to the U.K. PRIIPs Regulation,7 the combination of which have or will lead to differences between the EU and the U.K. PRIIPs regimes. The FCA has been granted a new power to make rules specifying whether a product or product category falls within the definition of a PRIIP. In addition, performance scenario requirements have been replaced with a more flexible requirement for "information on performance" to address industry concerns that, in certain circumstances, performance scenarios could be misleading.8
The FCA's proposals cover new rules on the scope of the products within the scope of the PRIIPs regime, new guidance on what it means for a financial instrument to be "made available" to retail investors and amendments to certain aspects of the U.K. PRIIPs TS. The changes are made in the context of the FCA's overarching aim, described in its 21/22 Business Plan,9 to ensure that consumers can access appropriate investment products and make effective decisions. The proposed changes to the PRIIPs disclosure requirements also aim to ensure that retail investors have understandable information available that enables them to make informed decisions, which is aligned with the FCA's proposals to introduce a new consumer duty. We discuss this further in our client note, "UK Conduct Regulator Proposes Consumer Duty for Retail Activities."
Responses to the FCA's PRIIPs consultation may be submitted until September 30, 2021. The FCA is aiming to finalize the amendments by the end of 2021, with a view to them taking effect on January 1, 2022. This client note summarizes the key proposals.
Summary of the UK PRIIPs Requirements
The U.K. PRIIPs Regulation applies to manufacturers of PRIIPs that are or will be made available to retail investors in the U.K. and to firms advising on or selling PRIIPs. These entities are within scope regardless of whether their business involves the provision of regulated financial services activities. The U.K. PRIIPs Regulation sets out rules on the format and content of the KID to be drawn up by PRIIP manufacturers before PRIIPs are made available to U.K. retail investors. The KID is intended to provide retail investors with information that will enable them to understand and compare the key features and risks of a PRIIP.10
The Regulation applies to "packaged retail investment products" and "insurance-based investment products."11 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 (such as, for example, investment funds, structured products and derivatives like options, future and CFDs), 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.12 The U.K. PRIIPs Regulation also applies to "insurance-based investment products." However, these are not discussed in this client note.
The U.K. PRIIPs Regulation and U.K. PRIIPs TS impose detailed obligations on PRIIP manufacturers (any entity manufacturing a PRIIP or making changes to an existing PRIIP, i.e. issuers and potentially underwriters), and sellers (persons offering or concluding a PRIIP contract with a retail investor, i.e. underwriters and other downstream distributors of capital markets instruments). Key obligations are:
- Publication of a KID. PRIIP manufacturers must produce and publish a KID on their website before the PRIIP can be made available to retail investors in the U.K.13 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 information on performance.14
- Provision of the KID in good time. PRIIP sellers must provide KIDs to the retail investor in "good time" before the retail investor is bound by any contract relating to that PRIIP. 15
The U.K. 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.16
Proposed New Rules on Scope
The EU and U.K. PRIIPs Regulations have had a significant effect on practices in the wholesale capital markets. Uncertainty about whether some financial instruments qualify as a PRIIP has resulted in issuers being cautious in their interpretation of the PRIIPs regime and either producing KIDs unnecessarily or excluding retail investors from offerings entirely, including straightforward bond issuances. Although intended as a measure to regulate disclosures on packaged retail products, such as FTSE trackers and insurance-wrapped investments, the very broad and generic definition of a PRIIP is likely to include most corporate bonds and most kinds of derivatives. There is uncertainty about whether corporate bonds with common features such as make-whole and change of control puts would lead to "fluctuating returns" for investors, leading to the bonds being subject to the requirements of the EU or U.K. PRIIPs Regulations. We discussed these issues and presented an alternative analysis in our client note, "PRIIPs and Capital Markets Transactions: A Better Way Forward?"
To address these challenges and avoid further consumer harm, the U.K. government decided to grant the FCA powers to make rules on the scope of the products subject to the U.K. PRIIPs Regulation. This approach provides much needed legal certainty, which the EU has not been able or willing to provide.17
In its consultation, the FCA is proposing to make rules, which will have legal effect, to clarify whether certain features of corporate bonds make a product a PRIIP. The FCA's proposed rules set out debt securities that are PRIIPs, those that are not PRIIPs, and features of debt securities that are neutral. Many of the FCA's proposals reflect our analysis as set out in the aforementioned client note. The FCA's proposed rules (to be set out in a new Product Disclosure sourcebook) are:
- Debt securities are a PRIIP where the level of interest
payable, any conditionality of principal repayment or the
issuer's default risk is linked to:
- fluctuations in reference indices or benchmarks relating to investment assets, excluding the Bank of England official Bank Rate and benchmarks or indices that relate to the performance of the general economy (e.g. those tracking the rate of inflation or money market interest rates); or
- the value or performance of reference assets, including a basket of shares; or
- the value or performance of investments held by the issuer (or an entity connected to the issuer, including members of the same group), such as derivatives, real estate, a pool of receivables, or a portfolio of securities.
- A debt security would not be a PRIIP where the:
- return on the security is determined by the economic performance of the issuer's (or, where a bond is guaranteed by a group entity, that entity's) commercial or industrial activities. The FCA adds that lending, investment, and any other financial sector activities would not be considered commercial or industrial activities of an issuer; and
- terms of the debt security do not impose any modification, structuring, or conditionality on the issuer's obligation to pay interest or repay the principal, except for the effect of certain neutral features (about which, see below).
- The following "neutral" features would not cause a
debt security to be considered a PRIIP:
- Fixed rate bonds, even if the coupons are subject to pre-defined changes (because the returns to investors for these investments are not subject to fluctuations).
- Floating rate bonds provided the interest payable is: (i) determined by the Bank of England official Bank Rate or indices that relate to the performance of the general economy, with or without a spread indicating the issuer's credit risk; and (ii) not subject to any modification or structuring (for example, a cap or a floor other than zero).
- Subordinated bonds, and bonds with perpetual or indefinite terms.
- A put option where the investor has a discretion to demand early repayment of the debt security on pre-agreed terms, or to convert or exchange into one or more shares of the same issuer at a pre-determined price.
- A call option that permits the issuer to redeem early at least at par, provided that exercise of the option is not linked to fluctuations in reference values or investment asset performance and the mechanism to calculate the net present value of the future coupon payments is made clear to the investor.
The FCA's view is that these types of put or call options that include, but are not limited to, make-whole or change of control clauses do not render a product to be as complex as other products that are certainly PRIIPs.
The FCA also intends to introduce a rule to clarify that a financial instrument issued before January 1, 2018 is not a PRIIP, even if it remains available for trading on a secondary market to retail investors. This would be a most welcome clarification of the position on legacy products as it would create much greater legal certainty than was achieved in the Guidelines issued by the European Commission in 2017.18
Proposed New Guidance on "Made Available"
Under the U.K. PRIIPs Regulation, issuers must produce a KID whenever PRIIPs that they are issuing are "made available" to U.K. retail investors. There is some ambiguity in terms of what constitutes "made available," which has led some firms to produce a KID even where they do not intend to sell the product to retail investors, to avoid inadvertently falling foul of the rules.
To combat this, the FCA proposes new guidance setting out the conditions in which PRIIPs will not be "made available" to retail investors, namely where:
- it is clear from the marketing materials, including the prospectus if there is one, that the financial instrument is only being offered to "investors eligible for categorization as professional clients or eligible counterparties under the FCA's rules" and is not intended for retail investors;
- the issuer and, for the secondary markets, the distributor take reasonable steps to ensure that the financial instrument is targeted at only investors eligible for categorization as professional clients and eligible counterparties; and
- the financial instrument has a denomination or minimum investment of £100,000 or more.
Notably, according to the text of the proposed guidance, a financial instrument would not be considered as being made available to a retail investor where it is made available to a retail investor that has opted to be a professional client (i.e. an elective professional client).
Proposed Changes to the UK PRIIPs TS
The FCA is proposing to make numerous changes and improvements to the existing U.K. PRIIPs TS, ranging from information on performance and risk to transaction cost disclosure requirements. The proposals are discussed in the body of the consultation paper and a mark-up of the U.K. PRIIPs TS text is in an annex to it.
Information on Performance and Risk
The U.K. PRIIPs Regulation requires certain information, including in relation to aggregate costs and charges, investment risk and information on performance, to be disclosed in the KID. The U.K. PRIIPs TS set out the detailed information that must be included and the methodologies for calculating and presenting the information. In some cases, the U.K. PRIIPs TS requirements have been found to be overly prescriptive, leading to misleading information being included in KIDS. The FCA is proposing amendments to the requirements to tackle this issue.
Performance Scenarios Replaced with Information on Performance
The Financial Services Act 2021 has removed from the U.K. PRIIPs Regulation the reference to "performance scenarios," instead requiring a KID to contain "information on performance." However, the U.K. PRIIPs TS still contain the methodologies for calculating prospective performance scenarios, requiring firms to use historical data to make their calculations, which has caused some issuers to publish misleading scenarios. In January 2018, the FCA issued an initial response19 to concerns raised on this matter, permitting firms to accompany their scenarios with explanatory materials to provide further context.
Using its new powers to amend the U.K. PRIIPs TS, the FCA is proposing to remove, entirely, the requirement for performance scenarios to be included in KIDs. Performance scenarios would be replaced by a new set of information requirements (in new Annex 4A to the U.K. PRIIPs TS), including:
- the main factors upon which a PRIIP's return depends, information about the underlying assets or reference values and how the return is calculated;
- the relationship between the PRIIP's return and the underlying investment asset or reference value;
- the factors likely to affect future performance;
- the most relevant index, benchmark, target or proxy, together with how comparable PRIIP is to that reference point in terms of volatility and performance; and
- an explanation of favorable, negative and worst case scenarios for the product's performance.
The FCA proposes to retain the requirements for producing performance scenarios to the extent these are required to calculate the summary cost indicator.
The FCA has decided that KIDs should not include past performance information but welcomes any feedback that respondents may have on that decision.
Misleading Summary Risk Indicators
The U.K. PRIIPS Regulation demands that issuers include information on the risks associated with the product. The U.K. PRIIPs TS prescribe how those risks should be laid out, including a Summary Risk Indicator score between one and seven together with a narrative description of the product's main risks. Concerns have arisen that the U.K. PRIIPs TS methodology for producing SRIs has led to lower than expected risk ratings. The FCA therefore proposes the following amendments:
- A new requirement that PRIIPs manufacturers upgrade a product's SRI if they consider the risk rating is too low and notify the FCA of any such upgrade.
- PRIIPs issued by Venture Capital Trusts should not adhere to the U.K. PRIIPs TS methodology and should instead be assigned a score no lower than six. This is to take account of the high-risk nature of VCT products, which nevertheless tend to produce low SRI scores under the current methodology on account of their having fewer observable pricing data points.
The FCA is also proposing to extend the current 200 character limit on the narrative description of other significant risks to 400 characters.
Transaction Costs Disclosure Requirements
The U.K. PRIIPs TS include a methodology for calculating and presenting the cost of PRIIPs, including the direct and indirect costs to be borne by retail investors. The FCA considers that the accuracy of this cost reporting could be improved and so proposes to make changes or issue clarifications to the rules regarding anti-dilution, the calculation of costs for debt securities and index-tracking funds and the three-year transaction cost calculation period.
The FCA's proposals do not deal with "slippage," the calculation methodology for transaction costs which accounts for the difference between the execution price of a trade and the "arrival price" when the trade order is submitted to the market. The FCA considers that it has already addressed concerns about slippage in its "PRIIPs Call for Input Feedback Statement,"20 and believes that the slippage methodology is working as intended.
"Anti-dilution" is the mechanism by which a fund passes on to investors the costs it incurs when it buys or sells investments in response to flows into or out of the fund. Under the PRIIPs rules, firms are permitted to deduct any benefit arising from anti-dilution from their total transaction costs. However, in some instances this has led to negative transaction costs. The FCA proposes that the U.K. PRIIPs TS be amended so that firms must disclose anti-dilution benefits as part of their narrative description of transaction costs but must not consider anti-dilution benefits if, and to the extent that, they would take the total transaction costs to below zero.
Calculation of Transaction Costs for Debt Securities
Limited price availability, particularly in the case of OTC transactions in bonds, can impact the accuracy of transaction cost reporting. The FCA proposes to clarify how transaction costs for OTC bond transactions are calculated by requiring firms to check the fairness of the price before conducting the transaction. Under the proposal, firms should rely on the average of the best bid and best offer obtained from multiple counterparties to calculate the market mid-price of the bond.
Calculation of Transaction Costs for Index-Tracking Funds
Index-tracking funds typically carry out fewer transactions than actively-managed funds, meaning "slippage" may not be the most accurate way to calculate their transaction costs. Index-tracking funds may also send orders at pre-determined times, sometimes several hours before they intend to execute the order, which increases the risk of errors. The FCA proposes that index-tracking funds should calculate costs differently. Where the fund submits orders via an auction, the "arrival price" (i.e. price at which the order is transmitted to the market) should be the mid-price immediately before the auction. Where the fund executes a transaction at a predetermined time, the arrival price should be calculated at that predetermined time, even if it has been transmitted for execution earlier.
Understanding the Average Price
Transaction costs must be calculated based on the average costs over three years. The FCA proposes to clarify in the U.K. PRIIPs TS that the calculation should be made by calculating all transaction costs over the entire three-year period and take the average for the whole period, as opposed to calculating the average on a year-by-year basis.
Excluded from the Proposals
The proposed amendments will not apply immediately to undertakings for collective investment in transferable securities (including exchange-traded funds that are UCITS) or to non-UCITS retails schemes if the fund manager uses a NURS-KII instead of a PRIIPS KID. Those firms should continue to apply the UCITS Directive requirements on key investor information documents (KIIDS) until December 31, 2026 in line with the five-year extension to the exemption, which HM Treasury announced in June 2021.21
The proposals will not apply to funds falling within the scope of the Overseas Funds Regime, established under the Financial Services Act 2021. The OFR permits certain categories of funds (namely, EEA funds and overseas collective investment schemes that have been granted equivalence) to be marketed to U.K. retail investors. The FCA plans to launch a separate consultation on the pre-sale disclosure obligations for non-U.K. funds operating under the OFR. However, overseas funds other than EEA UCITS, and which are individually recognized as schemes under the Financial Services and Markets Act 2000, are currently treated as PRIIPs and so will fall within the scope of the FCA's proposals.
1 See FCA consultation paper, "PRIIPs - Proposed scope rules and amendments to Regulatory Technical Standards," CP 21/23, July 2021.
2 Regulation (EU) No 1286/2014 of the European Parliament and of the Council of November 26, 2014 on key information documents for packaged retail and insurance-based investment products.
3 Commission Delegated Regulation (EU) No 2017/653 of March 8, 2017 supplementing Regulation (EU) No 1286/2014 of the European Parliament and of the Council on key information documents for packaged retail and insurance-based investment products (PRIIPs) by laying down regulatory technical standards with regard to the presentation, content, review and revision of key information documents and the conditions for fulfilling the requirement to provide such documents.
4 Regulation (EU) No 1286/2014 as it forms part of U.K. domestic law by virtue of the European Union (Withdrawal) Act 2018.
5 Commission Delegated Regulation (EU) No 2017/653 (on presentation, content, review and revision of key information documents) as it forms part of U.K. domestic law by virtue of the European Union (Withdrawal) Act 2018.
6 You may wish to read our client note, The Future of Financial Regulation in the UK ("The Future of Financial Regulation in the UK | Shearman & Sterling"), which discusses the other amendments made by the Financial Services Act 2021.
7 Regulation (EU) No 1286/2014 as it forms part of U.K. domestic law by virtue of the European Union (Withdrawal) Act 2018.
8 Section 38, Financial Services Act 2021, inserting Article 4A and amending Article 8, U.K. PRIIPs Regulation. Section 38 came into effect on July 1, 2021 under the Financial Services Act 2021 (Commencement No. 2) Regulations 2021 (S.I. 2021/739).
9 See the FCA, Business Plan 2021/22 (Business Plan 2021/22 (fca.org.uk)).
10 Article 1, U.K. PRIIPs Regulation.
11 Article 4(3), U.K. PRIIPs Regulation.
12 Article 4(1), U.K. PRIIPs Regulation.
13 Article 5, U.K. PRIIPs Regulation.
14 Articles 6-8, U.K. PRIIPs Regulation.
15 Article 13, U.K. PRIIPs Regulation.
16 Article 11, U.K. PRIIPs Regulation.
17 The European Supervisory Authorities published a Supervisory Statement on the scope of application to bonds in October 2019 to provide some clarity, however, it does not have the force of law. See our blog, "European Supervisory Authorities Issue Guidance on Scope of Application to Bonds of the PRIIPs Regulation." The European Commission has also recently requested technical advice from the ESAs on a range of matters related to the EU PRIIPs regime, including whether certain of the exemptions should be maintained and whether the scope should be extended to more products (see Call for advice to the Joint Committee of the European Supervisory Authorities regarding the PRIIPs Regulation, dated 27 July 2021).
18 See our client note, "PRIIPs and Capital Markets Transactions: A Better Way Forward?" for details of the Commission's guidance and the remaining uncertainty.
19 FCA Statement on communications in relation to PRIIPs, dated January 24, 2018.
20 See the FCA FS19/01, PRIIPs Call for Input Feedback Statement, dated February 2019 (PRIIPs Call for Input Feedback Statement).
21 See our blog about HM Treasury's announcement, "UK Announces Extension of Exemption For UCITs From PRIIPS Disclosure Requirements" dated June 1, 2021.
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