As part of its overall strategy to repair the immediate economic damage triggered by the COVID-19 pandemic, the EU is about to adopt a “Capital Markets Recovery Package”. The aim of the reform is to implement targeted amendments to existing EU capital market rules in order to promote market-based finance as one of the core pillars of the EU’s coronavirus recovery strategy. This article sheds light on the key elements of the proposed reforms and assesses whether these regulatory adjustments may also help to finally advance the highly ambitious EU Capital Markets Union project.
By Franca Contratto (Reference: CapLaw-2020-74)
1) Background and Overview
In the wake of the outbreak of the COVID-19 pandemic the European Union is facing a drastic decline in economic growth. While major member states, such as Spain, the United Kingdom, Italy and France are among the worst affected economies (estimated declines in GDP vary between 9.4% and 12.4%), the EU’s cumulated economic performance is expected to shrink by 7.4% in 2020.
The EU has developed a broad strategy to mitigate the negative economic impact of the coronavirus pandemic. It comprises, among others, a EUR 1.8 trillion “Stimulus Package”, a “Banking Package” which intends to facilitate bank lending to households and businesses as well as a “Capital Markets Recovery Package”. While earlier efforts to create a pan-European Capital Markets Union (CMU) have so far borne little fruit, European policymakers now seem united in their conviction that well-integrated, deep capital markets will have a key role to play in financing the post-pandemic recovery. Whereas public companies across the EU anxiously seek to be recapitalized, thousands of small and medium-sized enterprises require bank loans at an unprecedented level.
Against this background, the Commission has proposed targeted amendments to the Prospectus Regulation (EU-Regulation No. 2017/1129, PR), the Markets in Financial Instruments Directive (EU-Directive No. 2014/65/EU, MiFID II), the Securitization Regulation (EU-Regulation No. 2017/2402, SR) and the Capital Requirements Regulation (EU-Regulation No. 575/2013, CRR). The goal of the reform is threefold: The Recovery Package seeks to (1) facilitate investments in the real economy, (2) allow for a rapid re-capitalization of public companies listed in the EU, and (3) to enhance banks’ lending capacity, primarily to ensure funding for small and midcap enterprises. In their entirety, these erratic pieces of a “regulatory jigsaw” seek to ensure that the EU will meet the extremely pressing challenge to secure funding for the post-crisis recovery and to re-establish long-term growth potential within Europe.
2) Contents of the “Capital Markets Recovery Package”
a) Introduction of a new short-form “EU Recovery Prospectus”
One of the key goals of the Commissions’ recovery package is to facilitate a rapid and easy re-capitalization for European issuers who have been heavily affected by the economic shock of the COVID-19 crisis. The Commission therefore proposes to introduce a new “EU Recovery Prospectus” which shall help issuers to reduce their debt-to-equity ratios by means of a simplified and cost-effective procedure. In the words of the Commission, the new disclosure instrument shall be “easy to produce for companies, easy to read for investors, and easy to scrutinize for national competent authorities”. To meet these goals, the “EU Recovery Prospectus” will be a stand-alone document limited to 30 pages which focuses on essential investor information, such as, e.g. risk factors. An amendment to the Transparency Directive (EU-Directive No. 2013/50, TD) proposed by the European Council would further allow member states to postpone the introduction of the new European Single Electronic reporting Format (ESEF) for issuers’ financial reports by one year.
However, according to the intentions of the EU Commission and the European Council, the EU Recovery Prospectus should have a strictly limited scope: It will only be available for well-seasoned issuers that have been listed for no less than 18 months and who seek to increase equity by issuing shares. The European Council has further highlighted the importance of restricting the simplified procedure to economically “meaningful capital increases”; it therefore proposes to limit the EU Recovery Prospectus to offers which are equivalent to no more than 90% of the outstanding capital thereby avoiding highly dilutive issuances. The simplified disclosure regime is meant to be temporary and designed to expire 18 months after the date of application of the Regulation.
In turns, the EU passport mechanism will fully apply to the EU Recovery Prospectus so as to encourage investments from all over Europe and thereby contributing to an even stronger, pan-European integration of national capital markets.
b) Light-touch Adjustments to the MiFID II-Regime
The Commission has further proposed a series of targeted amendments to EU-Directive No. 2014/65/EU (MiFID II). The key proposals can be characterized as follows:
– Phasing-out of paper-based disclosure: Currently, the default method for disclosure and client-related communications as provided for under MiFID II investor protection standards is paper based. To alleviate the regulatory burden on securities firms the Commission proposes to phase out paper-based communication, unless retail clients have explicitly requested so.
– Exemptions to product governance for non-complex investments: Financial services relating to non-complex (“plain vanilla”) bonds shall be exempted from product governance-related requirements as provided for in Article 24(2) MiFID II. The exemption applies no matter whether vanilla bonds are sold only to professional investors or also distributed to retail clients.
– Alleviations on reporting duties: The Commission proposes to eliminate or reduce certain reporting duties in order to ensure that market participants remain efficient and competitive despite the challenging environment of the economic downturn caused by the pandemic. The proposed alleviations include a suspension of best execution reports to be published by trading venues and systematic internalizers as provided for in Article 27(3) MiFID II (“RTS 27”) until 2022.
– Changes to derivatives rules regarding commodity underlyings: Risk reducing transactions in energy derivatives (oil, coal, natural gas and power) may play a key role to shield the real economy from high volatilities in energy prices due to the coronavirus crisis. To allow effective use of risk reducing transactions the Commission proposes changes to the position limit regime and targeted hedging exemptions.
Overall, the Commission has proved to be rather wise not to trade away established investor protection measures provided for in the MiFID II-framework. Political support from the European Council and the European Parliament will only be guaranteed if the proposed alleviations of the regulatory scheme do not considerably weaken protection for lesser-experienced investors and retail clients.
c) Enlarged Scope of the Simplified Securitization Framework (“STS”-Regime)
Another component of the planned EU capital markets recovery package targets the EU Simple Transparent Securitization Regime (EU-Regulation No. 2017/2402). Adopted with the goal to simplify and standardize the rules applicable to securitizations, the so-called “STS-Regime” has only just come into force on 1 January 2019. While much effort had been put into drafting a well-balanced set of market-friendly rules, recent figures speak a disappointingly clear language: As shown in a recent report of the European Financial Markets Association securitization volumes have seen a steady and sharp decline from a market high of EUR 182.5bn in 2018 to as low as EUR 28.7bn in mid-2020 (cf. AFME press release, European capital markets performance in 2020, 28 October 2020). Up until now the STS-Regime has apparently not proven the success hoped for.
Nonetheless, the European Commissions is convinced that securitizations will play a key role to increase banks’ lending capacities and thereby safeguard funding for SMEs who had been hit hard by the COVID-19 crisis. The Commission has, therefore, drafted significant amendments to the STS-Regime in order to incentivize the use of securitization as an effective tool to move risk off banks’ balance sheets. The proposed changes to Regulation No. 2017/2402 can be summarized as follows:
– Extension of the STS-Regime to on-balance sheet synthetic securitizations: Provided that certain criteria are met, banks using on-balance sheet synthetic securitizations should in the future profit from the STS-Regime. In contrast to true-sale securitizations where assets (e.g. mortgages, bank loans etc.) are sold to a Securitization Special Purpose Entity (SSPE) and transformed into tradeable securities, banks originating on-balance sheet synthetic securitization continue to own the underlying exposures. However, so-called arbitrage synthetic securitizations, which fueled the outbreak of the 2007/08 financial crisis, will not qualify to profit from the simplified STS-Regime.
– Removal of regulatory obstacles to allow for the securitization of non-performing exposures (NPEs): As a result to the economic downturn caused by the COVID-19 crisis, the volumes of non-performing bank loans are expected to grow considerably. The current STS-framework adopted by Regulation No. 2017/2024 was not designed to allow for NPE securitizations. The reform therefore seeks to remove specific regulatory obstacles so as to allow banks to offload non-performing exposures in an effective and transparent way.
To avoid greater risks for investors or for financial stability and to maintain the credibility of the securitization market, high prudential standards will have to be observed: Whereas Regulation No. 2017/2024 already provides for extensive disclosure requirements and for a prohibition to sell securitized instruments to retail investors, targeted amendments of the Capital Requirements Regulation No. 575/2013 will introduce specific capital requirements for synthetic excess spreads (SES). Supervisory authorities may impose comprehensive and severe sanctions in case of wrongdoing by any party involved in the securitization process. Originators who fail to comply with the relevant provisions of the STS regime risk a considerable monetary sanction (minimum of EUR 5 Mio./maximum 10% of the annual turnover); they may also be banned temporarily from issuing STS-securities and their products will be removed from the website listing STS-investments. Member states are free to introduce criminal charges.
3) Conclusion & Outlook
For decades, European economies have been predominantly bank-based. Despite ongoing efforts to establish a strong, fully-integrated European Capital Markets Union, statistics for 2019 confirm the persistent weakness of EU capital markets by showing that as little as 12% of European companies’ funding was raised on capital markets whereas the lion’s share (88%) is still being secured by bank loans (AFME press release, Capital markets union needs bolder action to tackle remaining obstacles,
12 October 2019).
However dramatic the consequences of the COVID-19 pandemic may be, there is a glimmer of hope that the crisis will also bring something good: The current policy proposals give reason to believe that the coronavirus crisis can act as a wake-up call to finally abandon the dangerously one-sided dependence on bank-based finance in Europe. Provided that EU policymakers take fast forward steps to readjust the current regulatory framework EU capital markets may deploy a considerable growth potential in the shadow of the crisis and thereby contribute to the creation of a more robust and resilient post-pandemic European economy.
Franca Contratto (franca.contratto@unilu.ch)