The EU Prospectus Reform 2012 and Consequences for Structured Products Prospectuses

Seven years after the entry into force of the harmonized EU prospectus regime with the EU Prospectus Directive 2003/71/EC (PD) and the EU Prospectus Regulation EC/809/2004 (PR), a major revision of the EU prospectus regime will enter into force on 1 July 2012 when EU member states will be required to implement EU Directive 2010/73/EU (Amending PD) into national law and the amendments to the PR set out in the delegated EU Regulation EU/486/2012 (Amending PR) will enter into force. Many of the changes will affect the prospectus documentation for structured products disproportionately, as one focus point of the change targets base prospectuses and significantly restricts the permitted contents of final terms while another focus point targets the summary which will gain in significance and become the key source of information for retail investors. This article analyzes selected areas of change of particular relevance for structured product issuers and describes initial trends how to cope with the new requirements.

By Martin Scharnke (Reference: CapLaw-2012-29)

1) Introduction

Exactly seven years after the entry into force of the first fully harmonized EU prospectus regime with the EU Prospectus Directive 2003/71/EC (PD) and the EU Prospectus Regulation EC/809/2004 (PR) on 1 July 2005, a major revision of the EU prospectus regime will enter into force on 1 July 2012 when EU member states will be required to implement EU Directive 2010/73/EU (Amending PD) into national law and the amendments to the PR set out in the delegated EU Regulation EU/486/2012 (Amending PR) will enter into force. See CapLaw-2012-12. Additional amendments to the PR addressing in particular the issuer consent requirement for retail cascades and required information on proprietary indices and on profit forecasts will be set out in a second amending regulation to the PR entering into force after July 2012, a draft of which was published by the EU Commission on 4 June 2012. This article analyzes four selected areas of change of particular relevance for structured product issuers and describes initial trends how to cope with the new requirements.

2) Relationship between Base Prospectus and Final Terms

The base prospectus regime was originally introduced to enable issuers to publicly offer large quantities of securities in an efficient manner without the need to obtain separate regulatory approvals for each security. Such individual securities can be documented by way of final terms if the specific security to be issued falls within the scope of the general characteristics set out in the base prospectus. Since its introduction, the base prospectus has proved to be a great success and has become the predominant prospectus form for structured products issuers. However, the European Securities and Markets Authority (ESMA) noticed that different regulatory practices in EU member states had developed with regard to the information that can be included in the final terms as well as the information which needs to be set out in the base prospectus and therefore approved by competent regulatory authorities. In the Amending PD the European legislator concluded that it should be clarified that final terms should  only contain information related to the securities schedule which is specific to the issueof securities and which cannot be determined at the time of preparation of the base prospectus (Recital 17 to the Amending PD), and that all other information needs to be set out in the base prospectus. It authorized the EU Commission to develop technical details on the format of base prospectuses and final terms. Under the delegated authority and relying on advice prepared by ESMA, the EU Commission has completely overhauled the requirements on format, presentation and permitted contents of final terms in the Amending PR.

a) Categorization of Information Items

In the Amending PR, the EU Commission has categorized each information item of the securities description into either category A, B or C. The intention underlying this categorization is to significantly restrict the extent to which new information which is not reviewed by regulatory authorities can be introduced into prospectuses by way of final terms. For any “category A” item, all information needs to be set out in full in the base prospectus and no additions or modifications are permitted to be made by way of final terms. For any “category B” item, the base prospectus must contain all the general principles while details not known at the time of approval of the base prospectus may be inserted in the final terms. For information classified as “category C”, the base prospectus can contain blanks which can be inserted in final terms.

The risk factors, the type of underlying and information on proprietary indices of the issuer in case of derivative securities are amongst the most prominent information items classified as “category A” and must therefore be set out in full in the base prospectus, thus leading to a reduction in issuing flexibility for issuers. ESMA has recently published initial guidance on the interpretation of “category B” items and how to distinguish between the general principles and details of any such information item (ESMA Prospectus Q&A 14th version June 2012, question 78). On the basis of this guidance, the term “details of any information item” will likely be interpreted narrowly by regulatory authorities and only include such items as reference rates, currencies or amounts. It will in particular not be possible to introduce any freely drafted text in final terms in relation to any “category B” information item. By way of example, in the Amending PR, the calculation of the interest and the payout of securities have been classified as “category B”; this requires issuers to describe (and regulatory authorities to review and approve) the methods, including the algebraic formulas to determine the interest and the payout of the product in the base prospectus, in full.

As a result of the categorization, base prospectuses will necessarily contain more detailed information on the securities, which will likely (assuming no change in the product spectrum) lead to an increase in the length of prospectuses. The changes will also significantly reduce the flexibility of issuers to access capital markets at short notice because any product modification not provided for in the base prospectus will require a new approval procedure with regulatory authorities irrespective of its significance for investors. Against this background, it is to be hoped that regulatory authorities will at least permit certain product modifications (such as payout variants or issue specific risk factors) to be introduced by way of supplements since a supplement can typically be prepared at much shorter notice than a new prospectus. ESMA is currently weighing its position on this but until guidance is published, which is currently expected to be published in the summer of 2013, each member state will have to develop its own interpretation on this question.

b) Format and Presentation of Final Terms

Further amendments affect the format and the structure of final terms. Influenced by market practices in the area of unstructured debt issues offered to professional investors where final terms are often prepared in a tabular form, the EU Commission has introduced new rules severely restricting the information that may be included in final terms. Under the new article 22 (4) PR introduced by the Amending PR, final terms may only: (i) set out information items classified as “category B” or “category C”; (ii) replicate or refer to options related to the securities description provided for in the base prospectus and (iii) contain additional information set out in the new annex XXI to the PR, such as information on countries where the offer takes place, additional information on the underlying, or example calculations for the payout.

By restricting the information that may be replicated in final terms, the EU Commission has effectively disallowed the established format of final terms used in certain structured products markets such as Germany. In these markets, market participants often prepared final terms in a consolidated format (which includes the terms and conditions of the securities completed with the concrete issuance terms but also other parts such as the risk factors) with a view to present to investors all relevant information on the securities in a single document and in an easily analyzable form. While it is clear that these practices will need to change going forward, the EU Commission did not go as far as prescribing the use of a tabular format for all final terms. In particular, article 22 (4) (c) Amending PR expressly permits that any information item (irrespective of the categorization) relating to the securities description in the base prospectus may include options, and where the securities description contains such options, the selected option may be replicated in the final terms.

Against this background, issuers of structured products will need to reconsider their approach to final terms documentation under the new rules. Nevertheless, by appropriately designing the options set out in the base prospectus, the possibility to replicate information items included as options in the securities description in the base prospectus should give issuers some room for maneuver for the preparation of final terms. Issuers should use this opportunity to find a solution for the presentation of final terms that best complies with the local law requirements and that is transparent and easily analyzable for investors.

In addition, the Amending PR requires that where an item described in the base prospectus is not applicable to a particular issue of securities, such item shall appear with the label “not applicable” in the final terms. It appears difficult to see the benefits of this disclosure in case of an offering to non-professional investors who cannot be expected to have deep knowledge of every option contained in the base prospectus. In any event, the consequences of this requirement should be fairly limited, because the requirement only applies to the specific information items required for the securities descriptions as set out in the annexes of the PR and not to all options provided in the base prospectus. By way of example, the label “not applicable” would have to be specified in relation to interest provisions in the case of zero coupon notes but it will not generally be required for any option provided for in the base prospectus that is not applicable to a particular security.

3) Coping with the New Summary

The second pillar of the PD reform targets the summary for prospectuses for securities with denominations of up to EUR 100,000 offered to retail investors. Although the EU legislator had already intended that the summary conveys the essential characteristics and risks associated with the securities and the issuer at the time the PD was originally adopted, summaries of base prospectuses in the past often fell short of this objective, typically containing only generic information on the securities to be issued under the program and offering only few details about the characteristics of an individual security. The EU legislator identified this deficiency and introduced rules to turn the summary into a short form document actually satisfying the objective of a key source of information for retail investors. In order to achieve this aim, it was decided that a separate security summary will need to be prepared for each security offered by way of final terms in addition to the base prospectus summary that exists at the base prospectus level. The base prospectus summary shall now contain different options and placeholders for the individual securities issue while for the summary for a specific security the applicable options are selected and the placeholders will be filled in. This securities summary shall then also be annexed to the final terms.

In addition, a second objective linked to the summary has been introduced. The summary shall now also serve as an investor tool to compare the characteristics of different securities. In order to achieve this objective, the PR prescribes that each summary addresses 94 separate information items allocated to five parts covering (i) an introduction including appropriate warnings, (ii) information on the issuer, (iii) information on the securities, (iv) the key risks for investors and (v) information on the offer. These information items which repeat and condense the most important disclosure items required for the full prospectus and are extracted from the respective annexes of the PR will need to be presented strictly in the order provided for in the PR giving issuers no flexibility on how best to structure the summary for various product types.

Despite of the impressive catalogue, article 24 (1) of the Amending PR limits the length of both the base prospectus summary and the securities summary to 15 pages or 7 per cent. of the length of the base prospectus (including the documents incorporated by reference), whichever is longer. Contrary to the existing rules under the PR which contained a size limit of 2,500 words in its recitals (but which was in practice often used as non-binding guidance only), it is to be expected that the new size limits will be actively enforced by regulatory authorities. Since no cross-references from the summary to other parts of the prospectus are permitted, brevity of disclosure will therefore be central in order to comply with the new requirements.

Issuers of structured products will likely also see their program architecture affected by the size limit for base prospectus summaries. Given that the characteristics (including the payout structure) of each product type will need to be described in some detail in the base prospectus summary, this will impose an inherent limit on the number of product types that can be included per base prospectus, in line with the intentions of the legislator.

While the importance of the summary in prospectus disclosure will increase significantlywith these changes, so will the costs for the preparation of the securities summary, in particular in cases of offerings in various countries on the basis of the EU prospectus passport since a translation into the local languages will become necessary. The objectives pursued by this part of the reform also overlap in large part with other short form product initiatives both on the European level and in certain EU member states. For example, the project on harmonization of rules relating to packaged retail investment products currently discussed on the EU level (PRIPs) and the product information sheet (Produktinformationsblatt) introduced in Germany in July 2011 both focus on short form product disclosure and address perceived deficiencies in information made available to retail investors, albeit from a distribution and not from a product production perspective.

It remains to be seen how the different regulatory initiatives will develop further in the future. In any case, it would be desirable that both short form product disclosure documents converge because no retail investor has any benefit from two similar but diverging standards. In relation to countries such as Germany where a separate short form product disclosure is already mandatory, it is important to focus on a standardization of the short form product descriptions both in the product information sheet and the new prospectus summary, ideally relying on similar short form product and risk disclosure wording.

4) Base Prospectuses with Separate Registration Document

One of the few areas where the prospectus reform is expected to bring greater flexibility is the description of the issuer. As a result of the deletion of the beginning of article 5 (3) PD which was interpreted as disallowing separate registration documents in case of base prospectuses by the Amending PD, it may become possible in the future to split up the program documentation into three separate documents: the issuer description contained in a separate registration document, the securities description, and the summary. Currently only the German regulator BaFin has publicly confirmed that each document can be approved separately and updated separately by way of supplements from 1 July 2012. But based on the clear intention of the legislator when deleting the beginning of Article 5(3) PD, it is to be hoped that other EU member states and ultimately ESMA will also follow the German interpretation and permit separate registration documents in case of base prospectuses going forward.

This change would increase the attractiveness of separate registration documents for base prospectuses in the future. This is particularly true in the case of issuers of structured products who will be confronted with the need to subdivide comprehensive base prospectuses covering a wide variety of products into various separate base prospectuses each covering a limited number of products only. Against this background of an increasing number of separate base prospectuses which require constant administration and updates, it would lead to a reduction in administrative burdens if the issuer description were isolated from the rest of the base prospectus and updated separately. Such structure would reduce the number of supplements required for structured products programs because a change to the issuer description would typically only require one single supplement approved by a competent authority irrespective of the number of securities descriptions which each only contain dynamic references to the registration document as amended from time to time.

5) Revocation Right of Investors

Since the introduction of the PD there have been discussions on the application of article 16 PD, in particular on the limits of the time periods during which a prospectus needs to be updated by way of a supplement and the time period during which an investor may exercise its right to revoke an acceptance to subscribe or purchase securities in the case a supplement is published. As part of the prospectus reform, article 16 of the PD has been amended with a view to clarifying the applicable legal requirements. As a result of the change, while the legal uncertainties have been reduced, this has at the same time resulted in a significant extension of the period during which investors can exercise a right to revoke a purchase of securities. This increases the potential risk exposure for issuers and in particular for structured products issuers with their typically long offer periods.

As regards the time period during which a prospectus needs to be supplemented, the Amending PD has clarified in article 16 (1) PD that the requirement to supplement prospectuses exists until the later to occur of the end of the offer and the beginning of trading of the securities on a regulated market, thus extending this period significantly to the latest possible date amongst the various views brought forward in relation to article 16 PD in its existing form.

Furthermore, the revocation right of investors set out in article 16 (2) PD was amended and broadened so that investors who have agreed to purchase or subscribe for securities prior to the publication of a supplement relating to an offer prospectus are entitled to revoke their acceptances within a period of two working days from the publication of the supplement, if the event giving rise to the supplement occurred prior to the end of the offer and prior to the delivery of the security. Regulatory authorities have also started to indicate that they will require issuers to specify in the supplement the concrete timing of the occurrence of the event giving rise to the preparation of the supplement in order to easily determine whether a revocation right for investors exists.

In addition, issuers will be free to extend the revocation period to more than two working days.

It is important to note that contrary to the current rules by which article 16 PD has been implemented in Germany, the exercise of a right of revocation will no longer be excluded if the acquisition of securities by the investor has been settled and the respective securities have been delivered to it. This means that in Germany the amendments to article 16 (2) PD by way of the Amending PD will lead to a significant extension of the revocation right, effectively providing the investor with a put option to return the acquired securities if the event giving rise to the supplement occurred prior to the delivery of the securities to the investor.

As a result of these changes, there will be an increased risk that investors will actually revoke their purchases. Given that any such revocation will likely lead to losses for issuers, it will become even more important to reduce the time period between the occurrence of the event giving rise to the preparation of the supplement and the publication of the supplement as far as possible.

6) Conclusion

The prospectus reform entails substantial changes affecting in particular the basic program architecture for structured products programs. Although officially titled a further step to reduce administrative burdens and increase Europe’s competitiveness (Recital 4 of the Amending PD), the prospectus reform will most likely lead to more complex and in aggregate even longer prospectus documentations and will also increase the documentation costs for structured products issuers. Even if due to the grandfathering provisions contained in the Amending PR some of the changes do not become operative for base prospectuses approved prior to 1 July 2012, issuers are well advised to prepare for the new rules as early as possible. This is because at the latest during the next annual update cycle, these changes will need to be reflected in the program documentations, and it is to be expected that some time will be required to adapt the documentation to the new requirements.