MiFID II/R: the first year in the primary markets

On 6 December 2018, ICMA published MiFID II/R and the Bond Markets: the First Year - An Analysis of the Impacts and Challenges of MiFID II/R Implementation Since January 2018.

It includes some specific coverage of the primary markets, which have been affected by MiFID as many underwriters participating in new issue syndicates are MiFID-authorised entities. These new measures include allocation justification recording (in relation to underwriting & placing), the inducements and costs & charges regimes, and product governance. The primary markets community has also experienced the Packaged Retail and Insurance-Based Investment Products (PRIIPs) regime, to the extent that certain bonds are potentially “packaged” and are being made available to retail investors in the EEA.

The provisions on allocation justification recording relate to MiFID firms providing a MiFID placing service to issuers being required to keep an “audit trail”, non-public written record of the justification for each investor allocation made. The rationale for this is to identify potential conflicts of interest, as underwriters look to balance the interests of their issuer clients with the interests of their buy-side relationships.

In practice, the underwriting community reached broad consensus on allocation recording principles, with the underwriter responsible for billing and delivery generally circulating an initial draft record that other syndicate members can then adopt (modifying it as relevant for their internal needs). The experience so far has mainly just resulted in added administration for underwriters, and it remains to be seen whether this measure will have meaningful benefits for issuers or investors.

The provisions on inducements and costs & charges require that firms providing MiFID services (eg order reception/ transmission to any investor “client”) disclose to their client in advance any fee/commission or non-monetary benefit received from a “third party” in relation to the client service. Firms must also inter alia disclose ex ante and annually ex post the costs and charges relating to the services and financial instruments concerned, (also “encompassing any third-party payments”).

In practice, agreement on whether these rules apply to the disclosure of underwriting fees has varied, depending on guidance from some national regulatory sources, the typeof fees involved and how individual underwriters and/or how individual transactions are organised. Moreover, the prevailing view is that investors have little or no interest in the level of bond underwriting fees as these are very rarely a material factor in making an investment decision regarding bonds.The PRIIPs regime requires any person “manufacturing” a “packaged” product, before it is “made available” to retail investors in the EEA, to publish a key information document (KID) of no more than three pages and then regularly review it, and if needed, publish a revised KID. Any person advising on,or selling, such a product must provide retail investors in the EEA with the KID in good time before those retail investors are bound by any contract or offer.

The product governance (PG) regime characterises MiFID II persons that “create, develop, issue and/or design financial instruments, including when advising corporate issuers onthe launch of new financial instruments” as “manufacturers”. It requires that collaboration between manufacturers mustbe documented in an agreement. MiFID II persons that “offer or sell”, or “offer or recommend”, financial instruments are “distributors” for PG purposes (with no connection to the manufacturer being explicitly required). Manufacturers must identify, and communicate to distributors, a compatible target market of investors and periodically review that target market. Distributors must identify their own target markets (by either adopting the manufacturer’s target market or refining it). These requirements are all applicable on a “proportionate” basis.

The PRIIPs regime is designed to enhance protection of retail investors participating in the structured products markets, while the PG regime imposes a type of suitability obligation on different market participants with respect to all products and investors. In this regard, the two regimes have significant problematic features that have led to unintended consequences, as well as raising concerns over the fundamental practicability of compliance.

Under PRIIPs, certain authorities have taken the position that the inclusion of a term or condition that deviates

only slightly from what is regarded as a plain vanilla bond will bring that security into scope as a packaged product, requiring a KID to be produced. An example would be the inclusion of a “make whole” provision. The fact that this and other terms can be to the benefit of investors but bring a bond within PRIIPs, combined with the fact that equities are not subject to the PRIIPs regime yet present greater risks to the retail investor, has led many to question the efficacy and rationality of the PRIIPs regime. Under PRIIPs, a KID must not only be accurate but may also be interpreted to require the inclusion of all material information. The imposition of this requirement with attendant issuer liability for both a three-page KID and a full 100+ page prospectus has not only created perplexity but more significantly led many issuersto refuse to produce a KID and instead restrict placement of newly issued bonds to non-retail investors in the EEA.

The PG regime has had similar consequences. It has effectively created an investor suitability obligation, not just at the point of sale (the approach taken in the past by regulation), but also imposing this obligation on issuers, underwriters, and secondary market sellers over theentire lifetime of the instrument. The practical burden of compliance with PG has caused many EU-originated issues to curtail altogether placement of bonds to retail investors (see the 2018H1 vs 2017H1 percentage change in EUR benchmark issuance reported in the Fourth Quarter 2018 edition of this Quarterly Report).

While the goal of these primary market aspects of MiFID and PRIIPs is enhanced investor/consumer protection, it seems the impact has mainly been an increase in administrative burdens and a reduction in retail access to the bondmarkets. ICMA will continue to engage EU authorities and national competent authorities to better achieve desired regulatory outcomes while maintaining resilient andefficient markets.

Contacts: Ruari Ewing and Leland Goss ruari.ewing@icmagroup.org leland.goss@icmagroup.org

Prospectus Regulation

The EU Prospectus Regulation is due to apply from 21 July 2019 and work is underway on developing Level 2 and Level 3 measures. A high-level snapshot of where things stand is set out in the box below.

Further information on the most recent developments, namely the publication by the European Commission of draft Prospectus Regulation Level 2 delegated regulation and annexes and a summary of other prospectus-related matters is also set out below.

Prospectus Regulation Level 1

The EU Prospectus Regulation is final and was published in the EU Official Journal in 2017. Certain parts of it are already in application but it will apply in full from 21 July 2019.

Level 2

Delegated regulation on prospectus format, content, scrutiny and approval and detailed disclosure annexes

The European Commission published a draft delegated regulation and disclosure annexes on 28 November 2018 and requested feedback by 26 December 2018. ICMA submitted its feedback on 21 December (see further details below). The Commission’s deadline to adopt the delegated acts is 21 January 2019 (this deadline is set out at Level 1).

RTS on key financial information for the prospectus summary, data and machine readability of prospectuses, advertisements, prospectus supplements and prospectus publication

ESMA published its Final Report on Draft RTS under the new Prospectus Regulation in July 2018 (see the last edition of this ICMA Quarterly Report for commentary). ESMA’s Final Report is now with the Commission, whowill decide whether to endorse the proposed RTS. We understand that, if the Commission decides to endorse the RTS without amendment, the European Parliament and the Council would have a one month “non-objection period” within which to consider the RTS. This period can be extended by one month. If the European Parliament and the Council do not object to the RTS within the relevant non-objection period, or both the Parliament and the Council tell the Commission before the end of the period that they do not intend to object to the RTS, then the RTS will be published in the Official Journal and will enter into force on the date specified in the RTS.

Level 3

ESMA Guidelines on Risk Factors

ESMA published a Consultation Paper on Guidelines on Risk Factors in July 2018. ICMA responded to that consultation ahead of the 5 October deadline. See the last edition of the ICMA Quarterly Report for further details.

ESMA Q&A on Prospectuses

It is anticipated that the ESMA Q&A on Prospectuses will require updating in order to reflect the provisions of the new Prospectus Regulation. The timing for that update is not yet clear.

Level 2 delegated regulation on prospectus format, content, scrutiny and approval and detailed disclosure annexes

(i)Background

The most recent development in relation to the development of the new Prospectus Regulation regime is the publication by the Commission of a draft delegated regulation and disclosure annexes on 28 November 2018. Once finalised, the delegated regulation and annexes will form the bulk of the Level 2 provisions under the new Prospectus Regulation.

The Commission’s publication follows ESMA’s Final Report on Technical Advice under the Prospectus Regulation, which was published at the end of March 2018. The Q3 2018 edition of this ICMA Quarterly Report included an article on page 22-23 on the content of that Final Report.

The Commission requested feedback on the draft delegated regulation and disclosure annexes by 26 December 2018. ICMA submitted its feedback on 21 December.

(ii)Summary of ICMA feedback to the Commission

The opportunity to review the Commission’s proposed draft delegated regulation and annexes was welcome. However, the time allowed to formulate and provide such feedback, combined with the significant drafting changes that were made to the proposed provisions in ESMA’s Final Report on Technical Advice under the Prospectus Regulation meant that developing fulsome feedback on the draft delegated regulation and annexes was very challenging.

As a general point, debt capital market participants had previously highlighted to the Commission and ESMA that they, and NCAs, are familiar with the existing Prospectus Directive Level 2 provisions. It was therefore considered to be helpful that ESMA had not departed significantly from the language of the existing Prospectus Directive regime in the ESMA Final Report. Market participants expressed surprise at the Commission’s approach of amending much of the precise drafting contained in the draft delegated regulation and draft annexes.

It appears that there was no intention to change the approach set out in ESMA’s Final Report substantively. However, in some cases the drafting changes resulted in substantive differences and/or unclear disclosure requirements that could be problematic for NCAs and market participants if they are not rectified in the final delegated regulation and annexes.

ICMA submitted detailed feedback to the Commission highlighting those areas of the delegated regulation and annexes where it appeared that the drafting changes had inadvertently changed the position or resulted in an

Market participants expressed surprise at the Commission’s approach of amending much of the precise drafting contained in the draft delegated regulation and draft annexes.

unclear disclosure requirement. Some of the particular points of concern that ICMA flagged were as follows:

•The provisions of the delegated regulation relating to the circumstances in which certain non-equity securities disclosure annexes should apply are difficult to interpret and, in some cases, could be read as being out of line with the Level 1 position.

•Various provisions related to the interaction of final terms and base prospectuses that were included in ESMA’s Final Report on Technical Advice under the Prospectus Regulation and reflected the position in the current Prospectus Directive Level 2 regime have not been carried forward to the draft delegated regulation and annexes. Although it does not appear that there is any intention to change the current approach on these matters, it is not clear why those provisions were not carried forward and in many cases it would be helpful if they were set out explicitly at Level 2.

•Persons responsible for the prospectus are required by the disclosure annexes to give a responsibility statement in the prospectus. The precise wording of these disclosure requirements has been amended in different ways in different annexes and it is no longer clear exactly what the responsibility statements would be required to say. Again, it does not appear that this was an intentional change, as the new disclosure requirements do not make sense grammatically in most cases. There are other, similar, changes in the draft annexes where drafting changes have resulted in disclosure requirements that no longer seem to make sense grammatically.

The draft disclosure annexes envisage that, where a PRIIPs KID is used as part of the prospectus summary (which can be required by individual NCAs pursuant to Article 7(7) of the Prospectus Regulation), then any information disclosed in the summary from the PRIIPs KID would also need to be disclosed elsewhere in the

prospectus. There are concerns that this could result in unexpected results in practice.

•There is likely to be continued uncertainty in relation to the precise approach that will need to be taken in relation to the new risk factor disclosure requirements, which

is expected to be one of the most significant practical changes for issuers under the new Prospectus Regulation regime when it enters into force on 21 July 2019.

•In relation to credit-linked securities, the effect of making the disclosure of information relating to the reference entity (or the issuer of the reference obligation) Category A is that it will effectively prevent issuers making

such issuances under final terms, unless they have supplemented their base prospectus with the relevant information, which will add cost and time to the issuance process.

There were some positive elements to the Commission’s draft delegated regulation and annexes. These included:

•the Commission’s decision not to take forward the suggestion in the ESMA Final Report that a length limit on prospectus cover notes should be imposed;

•the Commission’s efforts to address the detailed comments that ICMA submitted to ESMA on the simplified disclosure regime for secondary issuances to ensure that such regime is not more onerous than the disclosure regime for primary issuances;

•the Commission’s change to the tax disclosure requirement so that it now refers to the issuer’s “country” of incorporation rather than the issuer’s “Member State” of incorporation, which is helpful for third country issuers; and

•the deletion of the definition of “debt securities” because the reference in that definition to the obligation to pay the investor 100% of the nominal value had led to certain securities such as zero coupon notes falling outside

the definition of “debt securities” under the current Prospectus Directive regime, which was problematic and confusing in practice.

(i)Next steps

ICMA intends to follow up with Commission contacts in relation to the feedback it submitted in writing.

The Level 1 Regulation provides that the Commission’s deadline to adopt delegated acts in these areas is 21 January 2019 (ie six months ahead of the implementation date).

Other prospectus-related matters

ICMA is monitoring developments related to the European Commission Action Plan on Financing Sustainable

Growth published in March 2018, under which the Commission announced its intention to specify by Q2 2019 the content of the prospectus for green bond issuances to provide potential investors with additional information.

Overall, we are expecting a busy period ahead for ICMA primary market members as they begin to prepare for the implementation of the Prospectus Regulation on 21 July 2019.

For many members, the impact of Brexit will be one part of those considerations. ICMA has published FAQs on the impact of Brexit in primary markets for its members, including a FAQ on the impact of Brexit on pan-European bond prospectus approval. ICMA will keep this FAQ under review and will aim to support members through the period ahead.

Contact: Charlotte Bellamy

charlotte.bellamy@icmagroup.org

US Resolution Stay Regime

The US banking regulators adopted rules known as the “QFC stay rules” in 2017 to improve the resolvability and resilience of US G-SIBs and their subsidiaries worldwide, as well as the US subsidiaries, branches and agencies of non-US G-SIBs.

The rules are intended to mitigate the risk of destabilising terminations of certain contracts, which is a perceived impediment to the orderly resolution of a G-SIB. They accomplish this by requiring that those contracts include

new language establishing that US regulators have the same ability to stay enforcement of termination of such contracts and to transfer such contracts away from a failing G-SIB that they would have under US bank insolvency law.

The background to these rules is a global FSB initiative related to the effective resolution of G-SIBs. The US rules are similarin concept, but different in their precise detail, to the UK’s PRA contractual stay rules (see the Q2 2016 and Q3 2016 editions of this Quarterly Report for further information on the UK rules).

On 20 December 2018, ICMA published a note setting out a summary of the effects of these rules on capital markets

documentation for vanilla, non-structured debt securities in primary markets outside the US (including some suggested language for relevant contracts) and associated FAQs. ICMA also inserted new language into the ICMA Agreement Among Managers version 1 and version 2 (contained in the ICMA Primary Market Handbook) to bring those agreements into compliance with the rules.

For vanilla DCM transactions outside of the US, the rules are most likely to be applicable where a US G-SIB is involved in the transaction. The rules apply to “qualified financial contracts”, which is likely to include a subscription agreement, the ICMA Agreement Among Managers version 1 and version 2 and a dealer agreement. It does not, however, typically cover other capital markets documents such as a trust deed, agency agreement, deed of covenant or the security instrument itself. The rules may apply to contracts that are governed by the laws of the US as well as any other laws.

It is important to note that the rules do not require amendments to all qualified financial contracts. Instead, a qualified financial contract is only “in-scope” if it restricts the transfer of the contract (or a related interest or obligation)

away from an entity that is covered by the rules, or provides for “default rights” that may be exercised against such an entity.

The first compliance deadline under the rules was 1 January 2019. The rules envisage a “phased compliance” periodwith different compliance deadlines applicable to different qualified financial contracts depending on the identity of the counterparties to the contract. ICMA understands that, notwithstanding the phased compliance deadlines, its US

G-S B members have been seeking to comply with the rules from 1 January 2019.

The precise impact of these rules for primary debt capital markets practitioners is difficult to state at this early stage. The ICMA publications noted above and other awareness- raising measures, along with initiatives by other trade associations such as ISDA (which has published the ISDA 2018 US Resolution Stay Protocol) are intended to help ease the burden of implementation.

Contact: Charlotte Bellamy

charlotte.bellamy@icmagroup.org

ICMA Primary Market Handbook: recent updates

On 19 December 2018, ICMA published several updates to the ICMA Primary Market Handbook and communicated this to ICMA members and ICMA Primary Market Handbook subscribers and holders via a circular (ICMA login details are required to access the circular online).

The changes were as follows:

•A new Recommendation R3.10 was inserted in Chapter 3 relating to prior syndicate consensus for any target market dissemination under MiFID II’s product governance regime.

•The ICMA Agreement Among Managers v1 and v2 was amended to include new clauses related to the new US special resolution regimes (see the article on this topic above).

•The ICMA form of Singapore selling restrictions were amended to reflect certain amendments to the Securities and Futures Act of Singapore that took effect from 8 October.

Further information (including open links to the amended pages) is available on the ICMA Primary Market Handbook amendments/archive webpage.

Contacts: Ruari Ewing and Charlotte Bellamy

ruari.ewing@icmagroup.org

charlotte.bellamy@icmagroup.org