Most Swiss financial service providers have been aware of, and have been preparing for, the effect the new EU regulation on key information documents for packaged retail and insurance-based investment products or “PRIIPs” will have on the offering of structured products and other complex financial products. However, recent attention in connection with the medium term note program update season in Europe has been paid to potential effects that the regulation may have on the offering of plain vanilla bonds and the corporate bond market generally. This article discusses these potential effects, including those that may be of particular importance to the Swiss financial market.
By Lee Saladino / Andreas Josuran (Reference: CapLaw-2017-27)
In December 2014, Regulation (EU) No. 1286/2014 of the European Parliament and of the Council of 26 November on key information documents for packaged retail and insurance-based investment products (the PRIIPs Regulation) came into effect and will directly apply in all Member States of the European Union and the European Economic Area (the EEA) commencing on 1 January 2018. The PRIIPs Regulation requires persons who manufacture, advise on or sell packaged retail and insurance-based investment products (PRIIPs) to provide retail investors with, and sets out uniform rules on the form and content of, a key information document (KID). The stated purpose of requiring the provision of a KID is to help investors to understand and compare the key features and risks of the PRIIP.
While one of the key objectives of the PRIIPs Regulation is clearly the harmonization and improvement of disclosures relating to more complex financial products such as investment funds, life insurance policies with an investment element, structured products and structured deposits, it lacks a clear-cut definition of exactly what financial products are in scope. The PRIIPs Regulation defines PRIIPs generally as “products […] where the amount repayable to the retail investor is subject to fluctuation because of exposure to reference values, or subject to the performance of one or more assets which are not directly purchased by the retail investor”. Furthermore, while the PRIIPs Regulation includes examples of certain products that do not fall within the scope of this definition, it does not set forth an exhaustive list. Despite the PRIIPs definition referring to the amount “repayable” being subject to fluctuation (which on its face would not pick up interest payments linked to a floating rate) and such fluctuation being specifically linked to exposure to reference values or the performance of assets, a certain amount of uncertainty has developed as to whether even certain types of “plain vanilla” bonds (i.e., fixed rate, floating rate and zero coupon) will qualify as PRIIPs. There seems at least to be a consensus that a fixed rate bond that redeems at par with no other special features (including no early redemption feature) would clearly fall out of scope since no amount repayable (or payable) to investors would be subject to fluctuation. However, due to the broad nature of the PRIIPs definition and certain confusing messaging from the European Commission and the European supervisory authorities (ESAs), many UK law firms have taken the position that there is a not negligible amount of uncertainty as to whether other plain vanilla bonds, such as those with a floating rate of interest and/or a make-whole or other early redemption feature, would be categorized as PRIIPs.
While there is hope that a sufficient amount of clarity will be obtained regarding the treatment of plain vanilla bonds under the PRIIPs Regulation before 1 January 2018, there has been some debate as to how issuers, underwriters and other primary market participants should proceed in the event that this does not happen. If a plain vanilla bond were considered to be a PRIIP and sales to retail investors were not to be excluded, the manufacturer (which in the plain vanilla bond context will almost always be the issuer) would not only be required to prepare a KID prior to the bond being made available to retail investors, but would have to regularly review and (as may be required under the PRIIPs Regulation) revise and republish the KID during the entire life of the bond. In addition to the cost associated with this obligation, the issuer would be exposed to civil liability under the laws of the relevant Member State of the EEA for a KID that is misleading, inaccurate, inconsistent with the legally binding pre-contractual and contractual documents, or inconsistent with the form and content requirements set forth under the PRIIPs Regulation. Furthermore, any person advising a retail investor on or selling the bond to a retail investor would be obligated to provide such investor with the KID “in good time” before such investor is bound by any contract or offer relating to the bond. Finally, both the issuer (as manufacturer) and any person advising on or selling the bond would be required to establish appropriate complaint and redress procedures for retail investors. Understandably, both corporate bond issuers and underwriters have generally indicated a desire to avoid falling into this regime in the case of plain vanilla bond issuances, particularly in the case of bonds that have been traditionally targeted at wholesale investors within the meaning of the Prospectus Directive (i.e., bonds with a denomination of EUR100,000 (or equivalent) or more). Against this backdrop, many UK law firms appear to have taken a conservative view and are advising clients that, to be on the safe side, they should approach future issuances of plain vanilla bonds as if the bonds are PRIIPs.
In order to assist primary market participants in addressing the above-described uncertainty, in February 2017, the International Capital Market Association (ICMA) developed suggested selling restrictions and legends for plain vanilla bonds that may or may not constitute PRIIPs and where the issuer will not publish a KID. ICMA has included suggested language for debt programs under which bonds may be offered, and for standalone bond issuances that will be offered, on or after 1 January 2018. Although the PRIIPs Regulation does not contain any grandfathering provisions, it is hard to see what obligations would be placed on primary market participants thereunder in the case of plain vanilla bonds for which the primary distribution has been completed prior to 1 January 2018 (however, a separate analysis of obligations that may be placed on secondary market participants is required). Consequently, there is arguably a six-month period during which primary market participants can debate and analyze the best way to handle standalone bond issuances, whereas inclusion of PRIIPs-driven selling restrictions and legends was very much a hot topic during this year’s medium term note program update season in Europe. ICMA has presented two different options for debt programs: a blanket prohibition on offers to retail investors in the EEA on and after 1 January 2018 (“Option 1”), and a default prohibition on offers to retail investors in the EEA on and after 1 January 2018, that may be “turned off” for a particular drawdown under the program (“Option 2”). Notwithstanding these two options, ICMA has also indicated that since a full understanding of the implications of the PRIIPs Regulation for the plain vanilla bond market is still evolving, an issuer may choose, in the program context, to wait to amend its program documentation to address the PRIIPs Regulation until such understanding develops and, in any event, prior to commencing an offer on or after 1 January 2018 (“Option 0”).
In connection with this year’s medium term note program update season in Europe, which typically involves documentation governed by English law, it has been our experience that UK law firms – irrespective of whether they are representing the issuer or the program dealers – are suggesting that the ICMA-developed selling restrictions and legends be included in the documentation (i.e., either Option 1 or Option 2, but not Option 0). In addition, we have observed a strong push by certain of those firms to select Option 1 on the basis that it is the “safer” choice for market participants, even in cases in which the issuer uses the program exclusively for plain vanilla bond issuances. If most primary market participants elect to exclude the possibility of offers and sales of plain vanilla bonds to EEA retail investors out of an abundance of caution and irrespective of whether plain vanilla bonds (or particular subsets of plain vanilla bonds) would be categorized as PRIIPs under the PRIIPs Regulation, they run the risk of significantly shrinking and otherwise damaging the European retail corporate bond market.
For the Swiss financial market, which is one of the world’s leading (if not the leading) international wealth management centers, and has traditionally focused on Swiss and international retail clients (many of whom are domiciled in the EEA), the impact of excluding retail investors in the EEA could be particularly severe. In Switzerland, where a large number of corporate bonds (both those that are classified as wholesale and those that are classified as retail under the Prospectus Directive) are placed with retail clients booked in Switzerland. Consequently, exclusion of sales to retail investors in the EEA could mean not only that there may be a more limited supply of European retail corporate bonds, but that European corporate bonds subject to such a prohibition may not be placed (or may not easily be placed) with retail clients booked in Switzerland. There is the practical concern about “flowback” of any such bonds to retail investors in the EEA, as well as the inability of Swiss banks to place such bonds with their large number of retail clients (which include, for example, family offices) that are booked in Switzerland, but domiciled in the EEA. In addition, in the case of plain vanilla bonds, the PRIIPs Regulation defines “retail investor” as any person classified as a “retail client” under Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (MiFID II) (i.e., a client who is not a professional client), and does not (either directly or indirectly via MiFID II) appear to explicitly state that in order for a person to be considered to be a “retail client” thereunder, such person must be domiciled or otherwise located in the EEA. Consequently, banks in Switzerland potentially also need to consider whether a client domiciled and booked in Switzerland could still be considered to be a retail investor in the EEA (e.g., through citizenship).
It is worth noting that the Swiss Federal Financial Services Act (Finanzdienstleistungsgesetz) (FIDLEG), which was approved by the Swiss Federal Council of States on 14 December 2016, and is currently before the other chamber of the Swiss parliament (the Swiss National Council), contemplates a concept that is similar to the PRIIPs Regulation’s KID. The FIDLEG will require a basic information document (Basisinformationsblatt) (BIB) to be prepared in cases in which certain types of financial instruments are offered to private clients. It is expected that FIDLEG’s implementing ordinance will ensure that the requirements for BIBs are aligned with those applicable to KIDs under the PRIIPs Regulation. Notwithstanding this expected alignment, following widespread criticism regarding the suitability of a BIB beyond short-term financial investment products (particularly, structured products) that was raised during the FIDLEG public hearing process, the Swiss Federal Council of States broadened the types of financial products exempted from the requirement to provide a BIB and specifically exempted all debt instruments without “derivative elements”. While at first glance this appears to be helpful in the case of plain vanilla bonds placed in the Swiss market (in particular with respect to the domestic Swiss franc bond market where the bonds are primarily intended to be booked in Swiss accounts and typically trade in minimum denominations of CHF5,000), it is unlikely to mitigate the effect of the treatment of some or all types of plain vanilla bonds offered in the EEA as PRIIPs or provide any relief in the case of retail clients that are booked in Switzerland but may still be considered to be retail investors under the PRIIPs Regulation (whether through domicile, citizenship or otherwise).
ICMA is continuing to work with industry participants to find a solution for plain vanilla bonds that will address the concerns described above, as well as take into account the product governance rules set out in MiFID II, which will also affect plain vanilla bond issuances and apply in all Member States of the EEA as of 3 January 2018. In the meantime, we believe that market participants appear to be well advised not to limit their flexibility (i.e., use Option 2 or Option 0 in medium term note program documentation and take a wait and see approach to standalone plain vanilla bond issuances) until more clarity is reached, and Swiss market participants in particular should watch this space.
Lee Saladino (lee.saladino@homburger.ch)
Andreas Josuran (andreas.josuran@homburger.ch)