In January 2018, two next sets of European rules affecting debt capital markets offerings into the European Economic Area (EEA) have come into effect: the PRIIPs Regulation (EU 1286/2014) on key information documents for packaged retail and insurance-based investment products (PRIIPs) and MiFID II (Directive 2014/65/EU on markets in financial instruments). The PRIIPs Regulation requires that a key information document be prepared and published for all offerings to retail investors that are in scope of the regulation. Its applicability to different types of bonds has been subject to much debate. This article presents an overview of the new regulation and consequences for debt capital markets transactions that include offers to European retail investors. In addition, the article discusses the implications of the new MiFID II rules, which have imposed new product governance obligations on MiFID firms when they manufacture and/or distribute financial instruments. Both sets of rules have resulted in new selling restrictions and contractual provisions being introduced in bond documentation.

By Dorothee Fischer-Appelt (Reference: CapLaw-2018-46)

1) Overview

a) What is a PRIIP?

The PRIIPs Regulation includes a broad definition of what investment constitutes a PRIIP (Article 4(1), (2) and (3), and Recital 6): an investment, where “regardless of the legal form of the investment, the amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or to the performance of one or more assets which are not directly purchased by the retail investor” (Art. 4(1)), or an insurance-based investment product which offers a maturity or surrender value that is wholly or partially exposed, directly or indirectly, to market fluctuations. The Regulation lists examples of investment products such as investment funds, life insurance policies with an investment element, structured products and structured deposits. The characteristics of a PRIIP include that assets are packaged or wrapped together so as to create “different exposures, provide different product features or achieve different cost structures as compared with a direct holding”. The Regulation specifically excludes a list of products from its scope, including deposits solely exposed to interest rates as well as assets that are held directly such as corporate shares or any debt securities issued by, or guaranteed by, EEA member states or one of their regional or local authorities and related public international bodies and central banks (Art. 2). Third country sovereign entities are not specifically excluded from the scope in the body of the rules.

b) Retail investors

The Regulation defines retail investors as:

• Retail clients defined in Art. 4(1)(11) of MiFID II (i.e., a client who is not a professional client as defined in MiFID, which may include corporates, public sector bodies, local authorities and municipalities), or
• customers as referred to in the Insurance Mediation Directive (2002/92/EC), where they would not qualify as professional clients under Art. 4(1)(10) of MiFID.

c) KID

The PRIIPs Regulation requires a new, pre-contractual disclosure document to be prepared that needs to be “made available” before retail consumers invest in investment products that are PRIIPs. This key information document (KID) is a stand-alone document, although it may contain cross-references to other documents including a prospectus, and is intended to enable retail investors to compare products and make a more informed investment choice. The template for KIDs is set out in a delegated regulation (EU 2017/653), which comprises the regulatory technical standards implemented under the PRIIPs Regulation. The Joint Committee of the European Supervisory Authorities has also published Q&As on the KID. The KID should be no longer than three pages in length and has to be clearly separate from any marketing materials and not contain cross-references thereto. The key information presented needs to be consistent with the bond transaction documents, the offering memorandum and the bond’s terms and conditions.

The KID is a very technical document and includes a section titled “What are the risks and what could I get in return?” In addition, a summary risk indicator (SRI), supplemented by a narrative explanation of that indicator, has to be included as well as a standardised risk score between one and seven, based on quantitative analysis (Art. 6(1), (2)). Different methodologies are used in the SRI to calculate the risk score, depending on the characteristics of the product and whether the product has a performance history. The main methodologies estimate the risk based on historical changes in the price of the product or on other factors on which the product’s return is based or may be assumed to be based. In addition, firms are required to describe the other main risks that are not included in the SRI, although this is limited to 200 characters.

d) Responsibilities and Updating KIDs

A KID has to be produced by the “PRIIPs manufacturer” before it is made available to retail investors, and the manufacturer, in the case of debt securities typically the issuer, has to publish the document on its website. In practice, banks will help issuers with the preparation of KIDs, as some of the information included in a KID relates to marketing and investment returns. Any person selling a retail investor a PRIIP (including managers in a bond offering) must provide those investors with a KID before they are bound by any contract or offer relating to a PRIIP. There is no definition of what “make available” (Art. 5(1)) means under the Regulation, although it is likely that in addition to publication on a website a further distribution process would be required to ensure that the KID has been provided to a retail investor before the investor is taking its investment decision and with sufficient time to consider the decision.

A new requirement for bond issuers is the obligation to review the information in the KID regularly and make a revised document available promptly on their website where the review indicates that changes need to be made (different from the prospectus rules, where a prospectus once a transaction has completed does not need to be updated). In its PRIIPs guidelines, the EU Commission stated that this requirement does not mean that a ‘real time’ KID needs to be provided (although systems for producing such KIDs are allowed), but that the frequency with which the manufacturer must review and revise the KID depends on the nature of the PRIIP and the extent to which the information provided in the KID remains accurate and not misleading.

e) Territorial application

In its guidelines issued in July 2017 (OJ C 218/11, 7.7.2017), the EU Commission confirmed that non-EEA persons who produce or distribute PRIIPs are also caught by the Regulation if they sell products to EEA retail investors.

f) Penalties and Liability

There are significant penalties for not providing a KID before “making available” PRIIPs to a retail investor in the EEA. For legal entities, the fine can be up to EUR 5,000,000 or up to 3% of the total annual turnover or up to twice the amount of profits gained or losses avoided because of the infringement where those can be determined.

A retail investor who shows it has incurred a loss resulting from reliance on a KID may claim damages from the PRIIP manufacturer for that loss in accordance with applicable national law. However, the manufacturer will not have civil liability solely on the basis of the KID, unless at the time of the investment the KID is misleading or inaccurate, inconsistent with the relevant parts of the legally binding documents or inconsistent with the required form and content for a KID under the PRIIPs Regulation. This position is similar to the liability for summaries of prospectuses under the EU prospectus rules.

2) Bond Documentation and Selling Restrictions

In order to be sure not to trigger an obligation to prepare a KID, where a bond could be considered a PRIIP, market participants need to include selling restrictions and legends to ensure the bonds will not fall under the PRIIPs regime, excluding sales to EEA retail investors.

The International Capital Market Association (ICMA) has published standard form selling restrictions aimed at ensuring that no securities are offered or otherwise made available to retail investors where no key information document (KID) has been prepared. Different forms are available for program and standalone bond documentation.

The exclusion of sales to retail investors is different from the common selling restrictions under the Prospectus Directive (2003/71/EC) and the appropriate selling restrictions under the Prospectus Directive still have to be included (the combined ICMA form now includes a three-prong set of restrictions, combining the PD public offer regime and the PRIIPs Regulation). In particular, the definition of retail investor under the PRIIPs Regulation is not identical with the distinction between retail and “wholesale” securities under the EU Prospectus Directive, such that securities sold solely in denominations of at least EUR 100,000 may still be within the scope of the PRIIPs regime. In addition, excluding “qualified investors” under the Prospectus Directive would not be sufficient to ensure that there is no retail distribution under the PRIIPs regime and therefore both sets of selling restrictions have to be included.

The Prospectus Regulation (EU 2017/1129), which will apply in full from July 2019, creates a new “qualified investor” only segment of the market for non-equity securities, which will also still need PRIIPs restrictions due to the differences in definitions of retail investor. The Prospectus Regulation also provides that the prospectus summary may be substituted by the KID where issuers have produced a KID and home Member States are allowed to require that the prospectus summary be substituted by the KID.

Legends should also be included on announcements, and standard form wording is available for contractual provisions prohibiting sales in the EEA to retail investors.

3) Scope – which bonds are PRIIPs?

As noted above, the question of whether an investment constitutes a PRIIP, turns on whether the “amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or to the performance of one or more assets which are not directly purchased by the retail investor”.

For debt securities, their characteristics need to be considered on a case-by-case basis, unless the securities in question are very vanilla debt products, such as fixed or floating rate bonds with bullet redemption, or bonds redeemed at par, or bonds with fixed amortisation, as in each such case the amount repayable to investors is not subject to fluctuation. Securities that would likely be PRIIPs include securitisations, convertible bonds, products with exposure to underlying, subordinated debt and repackagings, bonds that include a put or call option, or bonds with make-whole features (a call provision that allows the issuer to pay off all or part of the debt early), as those features could make the “amount repayable” subject to fluctuation, even where that is only in a limited set of circumstances.

Absent specific guidance from the European Securities and Markets Authority (ESMA) on the issue, much debate has taken place in the last year in particular with respect to corporate bonds with “make-whole” clauses or callable bonds. In July 2018, the UK Financial Conduct Authority issued a “Call for Input regarding the PRIIPs Regulation”, including what the FCA could do to clarify the kinds of products covered by the new rules, specifically referring to the issue of whether certain corporate bonds are in or out of scope of the Regulation. The deadline for responses is 28 September 2018 and the FCA feedback statement is expected to be published in the first quarter of 2019.

It has been argued that “repayable” in the Regulation should be read to refer to a bond’s principal amount rather than any interest payments, which would significantly narrow the applicability of the PRIIPs Regulation and exclude from the scope bonds with make-whole clauses as well as floating rate bonds with coupon exposure to reference rates (see B. Reynolds/T. Donegan/K. Stehl/E. Teo/I. Song, Shearman & Sterling, Perspectives, PRIIPs and Capital Markets Transactions: A Better Way Forward?, April 26, 2018).

The EU Commission must review the PRIIPs Regulation by 31 December 2018. Therefore, further clarification and/or amendments may be published after that date, which may include more guidance on the scope of the Regulation and its applicability to particular types of bonds.

4) MiFID Product Governance

Another important new set of rules affecting debt capital markets are the MiFID II rules establishing a new product governance regime, which requires persons that manufacture or distribute financial instruments to have a specified process for approval of each financial instrument and to identify a compatible target market of investors for each financial instrument and assess all risks relevant to the identified target market in order to ensure that the financial instrument and intended distribution strategy are consistent and compatible with the needs and objectives of the identified target market. This regime has to be complied with in an “appropriate and proportionate” way. ESMA has published Guidelines on product governance requirements that manufacturers should use when considering the potential target market for a financial instrument, including the type of clients, their knowledge and experience, financial situation with a focus on the ability to bear losses, risk tolerance and compatibility of the risk/reward profile of the product with the target market and the clients’ objectives and needs.

A MiFID firm is an investment firm established in the EEA and subject to MiFID II, and it is considered a manufacturer if it is one that is involved in the creation, development, issuance and/or design of the bonds. Banks have internal policies in place to determine whether they are a MiFID firm manufacturer on a bond issue. In the case of a bond offering, the lead manager acting as adviser to the issuer would be treated as the manufacturer under MiFID II and would have to establish and maintain policies for approval of the debt securities before they are marketed and distributed to an identified target market and for periodic review thereof. A lead manager would also likely be a distributor in a bond issue (and would therefore comply with both obligations as manufacturer and distributor), whereas any other MiFID firms in a syndicate of underwriters offering or recommending the bonds would be distributors. Distributors determine the actual target market by adopting the manufacturer’s target market or refining it.

Where the lead manager is not a MiFID II firm (e.g., because it is not established in the EEA), but another distributor is a MiFID II firm, then that other manager would be obligated to seek information from the lead manager and would determine its own target market of EEA investors for the bonds. Where none of the issuer or any of the managers is a MiFID firm manufacturer, the product governance obligations do not apply and the parties do not need to identify a target market of investors for the bonds. Typically, under this fact pattern no MiFID legends would be included in the documentation. Where a non-EEA issuer establishes a MTN programme, given that it is possible that a MiFID Firm accedes as a manager on a drawdown, MiFID legends are typically included. It has to be noted that the PRIIPs Regulation is entirely separate from MiFID and its applicability (and whether any legends are needed to exclude it) depends on whether any packaged products are sold to retail investors in EEA Member States.

MiFID II firms wishing to limit their disclosure requirements under MiFID II product governance rules may limit their identified target market to sophisticated investors by including legends and selling restrictions similar to those used under the PRIIPs Regulation and could use high denominations. ICMA has developed a paper setting out suggested procedures for bond offerings to professional investors only, including legends, a co-manufacturer agreement, high denominations, EEA selling restrictions and the absence of a KID, in an attempt to develop “appropriate and proportionate” compliance. In practice, these selling restrictions have been widely used whenever a MiFID firm is involved in an offering, providing (in case of a stand-alone bond) as follows: “the target market assessment in respect of the Notes has led to the conclusion that: (i) the target market for the Notes is eligible counterparties and professional clients only… and (ii) all channels for distribution of the Notes to eligible counterparties and professional clients are appropriate. Any person subsequently offering, selling or recommending the Notes (a “distributor”) should take into consideration the manufacturer[’s/s’] target market assessment; however, a distributor subject to MiFID II is responsible for undertaking its own target market assessment in respect of the Notes (by either adopting or refining the manufacturer[‘s/s’] target market assessment) and determining appropriate distribution channels”.

5) Conclusion and Outlook

The application of the new MiFID II product governance rules and what constitutes “appropriate and proportionate” compliance continues to evolve in practice. For bond issuances, selling restrictions limiting offerings to eligible counterparties and professional clients have been widely used in practice. As to the PRIIPs Regulation, absent further pronouncements by EU authorities, or guidance from national EU regulators (such as the FCA), if there is a chance that a particular bond could be categorised as a PRIIP, issuers would want to prepare a KID prior to the bond being offered to EEA retail investors, unless there is certainty that the bond would not be sold to retail investors, in order to avoid potential liability for a breach of the PRIIPs Regulation, both on the part of the issuer and the distributing banks. In practice, many offerings are excluding retail offerings and using selling restrictions to that effect. From a policy point of view, it would be sensible for EU regulators to exclude bonds that are otherwise “plain vanilla” and only make the amount repayable subject to fluctuation in limited circumstances, such as in case of make-whole features which are often included in corporate bonds. There does not seem to be much value for retail investors to have access to KIDs for those corporate bond issuers to compare a bond in question to another bond, where the bond as such is not a complex structured instrument and the credit rating will turn on the underlying credit of the corporate issuer. It would also be helpful for EU regulators to exclude non-EEA sovereign offerings from the scope, and to clarify how KIDs have to be “made available” to investors. It remains to be seen, what clarifications ESMA and the EU Commission will provide as part of the year-end 2018 review foreseen in the PRIIPs Regulation.

Dorothee Fischer-Appelt (fischerappeltd@gtlaw.com)