The following article was first published in CapLaw on 7 March 2012 (CapLaw-2012-12).
In late 2010, we reported on certain key changes to the EU Prospectus Directive (2003/71/EC) as a result of EU Directive 2010/73/ EU (Amending Directive) of which Swiss issuers and capital markets practitioners should be aware. See CapLaw-2010-51. Once implemented (i.e. transposed into national law) by the various member states of the European Economic Area (EEA), the amendments will have a significant impact on both debt and equity offerings within the EEA. The deadline for implementation is 1 July 2012.
By the same deadline, the European Commission (Commission) must adopt certain delegated acts, i.e. corresponding amendments to Commission Regulation (EC) 809/2044 (Prospectus Regulation) to implement the new framework contemplated by the Amending Directive (Amending Regulation). Due to the need to provide legal clarity to market actors, the Amending Regulation is expected to be published in the Official Journal of the European Union by 1 July 2012. The Commission is relying on the European Securities and Markets Authority (ESMA) for technical advice on the amendments. ESMA has submitted the first and second part of its final advice to the Commission on 4 October 2011 and 29 February 2012, respectively, and the Commission has published a draft of the Amending Regulation on 30 March 2012.
On 20 January 2011, the Commission sent a formal request (Mandate) to ESMA to provide technical advice to the Commission on possible delegated acts concerning the Prospectus Directive as amended by the Amending Directive. The Mandate was split into three parts to permit ESMA to prioritise its work and the delivery of its technical advice.
Part I of the Mandate covers (i) the format of the final terms to a base prospectus – Article 5(5) Prospectus Directive, (ii) the format of the prospectus summary as well as the detailed content and specific form of key information required in the summary – Article 5(5) of the Prospectus Directive, and (iii) the proportionate disclosure regime introduced for some pre-emptive offers of equity securities, offers by SMEs and issuers with reduced market capitalization, and offers of non-equity securities referred to in Article 1(2)(j) by credit institutions – Article 7 of the Prospectus Directive. The Commission must adopt delegated acts with regard to item (i) by 1 July 2012 and ESMA submitted its final report with technical advice with regard to Part I (ESMA/2011/323) to the Commission on 4 October 2011.
Part II of the Mandate covers (i) consents to use a prospectus in a retail cascade – Articles 3 and 7 of the Prospectus Directive, and (ii) a review of the provisions of the Prospectus Regulation – Articles 5 and 7 of the Prospectus Directive. ESMA submitted its final report with technical advice with regard to Part II of the Mandate (ESMA/2012/137) to the Commission on 29 February 2012. In its advice, ESMA proposes how to use a prospectus in a retail cascade and provides input on how to revise the provisions of the Prospectus Regulation concerning tax information, indices, auditor’s report on profit forecasts and estimates and audited historical financial information.
Part III of the Mandate finally covers (i) the equivalence of third-country financial markets – Article 4(1) of the Prospectus Directive, and (ii) a comparative table of the liability regimes applied by the EEA Member States in relation to the Prospectus Directive. In addition, the Mandate was subsequently amended to also cover convertible and exchangeable debt securities. ESMA has commenced work on the comparative table recording the liability regimes applied by the Member States. It will also address the disclosure requirements for convertible and exchangeable debt securities as part of the same technical advice and the Commission has set a tentative deadline of December 2012 for this project. However, ESMA has postponed work on equivalence of third-country financial markets due to the ongoing review of the Transparency Directive, Market Abuse Directive and Markets in Financial Instruments Directive (MiFID).
On 30 March 2012, the Commission published a draft of the Amending Regulation. This draft covers the matters included in Part I of the Mandate, but does not yet reflect ESMA's final report with regard to Part II of the Mandate. The draft also deviates in certain respects from the final advice provided by ESMA with regard to Part I of the Mandate.
Overall, ESMA's technical advice and the Amending Regulation are intended to strengthen investor protection, to increase the legal clarity and efficiency of the prospectus regime across Europe and to reduce the administrative burdens for specific issuers. The stated goal of ESMA's technical advice is to ensure that prospectuses provide investors with easily accessible information on financial products so as to foster informed decision making.
This article highlights certain key provisions of ESMA's technical advice on Parts I and II of the Mandate as well as the relevant provisions in the draft Amending Regulation of which all capital markets practitioners should be aware, but it is not intended as an exhaustive summary. If ultimately adopted by the Commission as currently proposed, some of the proposed changes to the prospectus regime may require significant changes to Prospectus Directive compliant base prospectuses, particularly for base prospectuses used in structured note programs.
1) Key Proposed Changes to the EU Prospectus Regime
The following is just a brief summary of some of the key proposed changes included in ESMA's final technical advice on Parts I and II of the Mandate and in the draft Amending Regulation.
a) Transition rules / "Grandfathering"
Helpfully, ESMA proposed to clarify that any delegated acts to be adopted by the Commission will only apply to prospectuses and base prospectuses which have been approved by a competent authority after the date of entry into force of those delegated acts. In particular, where a prospectus supplement is issued on or after 1 July 2012 in relation to a prospectus or base prospectus approved before that date, any supplements would only have to address the current requirements of Article 16 of the Prospectus Directive (e.g. a significant new factor, material mistake and inaccuracy in the prospectus arises or is noted after approval of the prospectus) without regard to the changes introduced by the Amending Directive. This would ensure that base prospectuses that were approved prior to 1 July 2012 can continue to be used after 1 July 2012 and need only be updated in the ordinary course in connection with a regular program update. Importantly, this would also apply to final terms issued under a base prospectus as well as requests to passport a prospectus post 1 July 2012 which had been approved prior to that date. However, where a registration document has been approved before 1 July 2012 and the prospectus is prepared on or after that date, the prospectus would have to meet the requirements of the Amending Directive.
Consistent with these ESMA recommendations, the transitional provisions in Article 2 of the draft Amending Regulation clarify that the provisions of the Amending Regulation with regard to (i) final terms as described under "b) Final Terms" below and (ii) summaries as described under "c) Summaries" below, will not apply to the approval of a supplement to a prospectus or base prospectus where the prospectus or base prospectus was approved before 1 July 2012.
b) Final terms
In response to ESMA's consultation paper on Part I of the Mandate, many industry participants had argued that certain proposals contained in the consultation paper would significantly detract from the success of the Prospectus Directive leading to a less flexible and less competitive marketplace for the issuance of securities in Europe. In particular, some respondents predicted that ESMA's proposals would most acutely impact the structured products market and that the entire structured products industry would be required to significantly adapt their existing base prospectuses at considerable cost to include the universe of potential features of products they expect to issue.
ESMA acknowledged in its final advice that its proposals will reduce the flexibility of the base prospectus regime but expressed the view that market participants had taken advantage of the lack of regulation of the current base prospectus system to disclose information in the final terms which it believes must be vetted by the competent authorities. It therefore argued that its proposed approach was necessary to prevent what it perceived to be "excesses" in the use of final terms as well as to strengthen and harmonize supervisory practices. In doing so, ESMA expressly acknowledged that that the base prospectus regime may not be the appropriate way anymore to issue certain financial instruments, but rejected concerns that financial innovation would be seriously compromised as issuers could always prepare a (product-specific) prospectus.
Similarly, the Commission stated that one of the objectives of the draft Amending Regulation was to address "inconsistencies" and "abuses" in market practices in different member states as a result of the lack of "precise mandatory disclosure requirements" with regard to base prospectuses and final terms.
i) Content of final terms
ESMA has proposed severe restrictions on the information that may be included in final terms by (1) prescribing a detailed list of items in the applicable securities note schedules of the Prospectus Regulation indicating by category (i.e. "Category A", "Category B" or "Category C") whether such items may or may not be included in final terms, and (2) imposing a number of other requirements and restrictions with respect to the content and layout of final terms.
ESMA's proposed categorization of items in the securities note schedules, which is also reflected in the Amending Regulation by way of proposed new Article 2a, determines the degree of flexibility by which the information can be given:
- “Category A”: The base prospectus cannot include any placeholder in respect of an item in this category. The relevant information must be included in the base prospectus and no additional information in relation to such item can be added in the final terms, but would require a supplement (if Article 16 of the Prospectus Directive is applicable) or a new prospectus.
- “Category B”: The base prospectus must contain all the general principles related to the required information and must only include placeholders for those details not known at the time of the approval of the base prospectus. Those missing details may be inserted in the final terms.
- “Category C”: The base prospectus may contain a placeholder, where information is not known at the time of the approval of the base prospectus. Such missing information may be inserted in the final terms.
In its final advice, ESMA clarifies that the proposed differentiation between the three different categories has less to do with whether information is known at the time of the approval of the base prospectus or could only be determined at the time of the individual issue, but that it has assessed the differentiation between categories A, B, and C mainly on the basis of whether information must be scrutinized by the competent authorities in accordance with Article 2 of the Prospectus Directive. Accordingly, while only information not known at the time of the approval of the base prospectus would be eligible for inclusion in the final terms, issuers would not automatically be entitled to include all such information in the final terms. With regard to risk factors, pay-out formulas and indices composed by the issuer, for example, ESMA has expressly affirmed the need for review by the competent authorities.
This means that it will not be possible anymore to include certain items in final terms. Instead, they must either be included in the base prospectus, in a supplement or in a new prospectus, which are subject to review by the competent authority. See also Recitals (5) and (7) of the draft Amending Regulation. In response to comments that the use of supplements was likely to increase significantly as a result of the proposed new rules, ESMA observed that when deciding whether it is appropriate to issue certain types of securities under the base prospectus regime, it would expect issuers to consider that a large number of supplements to one base prospectus may affect the readability of the documentation. As a consequence, ESMA expects and expressly encourages market participants to have recourse to more “specialized base prospectuses” or stand alone prospectuses.
ii) Replication of information in final terms / "Integrated Terms & Conditions"
In its consultation paper, ESMA had interpreted Article 26 (5) of the Prospectus Regulation in a way that final terms can only replicate “some” and not all information items from the securities note schedules, implying that, as long as securities note information is specified in the base prospectus, the relevant item must not be reproduced in the final terms. In doing so, some respondents to ESMA's consultation paper argued that ESMA had ruled out the possibility of including "integrated terms and conditions" in final terms, which is a well established practice in some European markets (e.g. Germany) for securities offered to retail investors. ESMA has rejected the argument made by some of those respondents that investors would be prevented from receiving a "full picture" in a single document by suggesting that the summary (see below) would provide this "full picture". In addition, ESMA notes that potential civil law problems (e.g. liability and consumer protection rules that may encourage the use of integrated terms and conditions in connection with retail offerings) should be resolved on the national level in each relevant member state. However, in its final advice, ESMA appeared to acknowledge that there may be a need to extract integrated terms and conditions from a base prospectus as the latter may not be easily analyzable and comprehensible to retail investors. On the other hand, ESMA also reminds issuers that the base prospectus has to be comprehensible in order to comply with Article 2 of the Prospectus Directive. In the draft Amending Regulation, proposed new Article 26, paragraph 5 of the Prospectus Regulation expressly provides that items of the relevant securities note schedule which are (required to be) included in the base prospectus must not be reproduced in the final terms, and proposed new Article 22, paragraph 4 provides that final terms must only contain (i) Category B and Category C information, (ii) on a voluntary basis, certain "additional information", and/or (iii) replications of, or references to, options already provided for in the base prospectus applicable to the individual issue. It therefore appears that the new regime will significantly limit the ability to include integrated terms and conditions in final terms.
iii) Deletion of non-applicable information in final terms
ESMA proposed that all non-applicable information must be deleted in final terms instead of being marked as, for example, “non-applicable” in respect of the specific issue, as this would improve the readability of the final terms documentation and enable investors to quickly locate the terms not previously known at the time of the individual issue. As a result, issuers and their advisers would likely have been required to spend more time on drafting and reviewing final terms and would likely have increasingly resorted to the use of templates, rather than precedent final terms from prior transactions (which would not have been able to include space holders anymore for features not applicable to the prior issue, but applicable to the subsequent issue). Again, this change would have disproportionately affected issuers under structured note programs, which often issue hundreds (or even thousands) of different products in very short order through the use of final terms. However, in the draft Amending Regulation, proposed new Article 22, paragraph 4(a), second sentence of the Prospectus Regulation expressly provides that when an item is not applicable to a prospectus, the item shall appear in the final terms with the mention "not applicable".
Under the new prospectus regime, the final terms for each individual issue to which the Prospectus Directive applies must be accompanied by issue-specific summaries. This requirement is particularly relevant for cross-border offerings as the issue-specific summary will be subject to the same requirements as to translation into other languages as the summary of the relevant base prospectus (Article 19 of the Prospectus Directive). See proposed new Article 26, paragraph 5a of the Prospectus Regulation.
With regard to the format and content of these issue-specific summaries, both ESMA and the draft Amending Regulation adopt a very rigid approach. Each summary must be broken down into five main sections in the following order: "A. Introduction and warnings", "B. Issuer and any guarantor", "C. Securities", "D. Risks", and "E. Offer". Proposed new Annex XXII contains a detailed list of "elements" to be included in each of these sections. Under the ESMA proposal, issuers would have been permitted to modify the order of these elements within each section (but not the order of the sections) and omit individual elements to the extent they are not relevant to the specific issue or issuer. In the draft Amending Regulation, however, proposed new Article 24, paragraph 1 of the Prospectus Regulation expressly provides that both the order of the sections and the elements will be mandatory and that wherever a disclosure item is not applicable to a prospectus, it must still appear in the prospectus and be expressly identified as "not applicable". The rationale for this rigid approach is to make it easier for investors to compare different products through their summaries, which the Commission believes will increase confidence among investors and facilitate greater competition on the European financial markets.
According to ESMA's technical advice, summaries should be read as an introduction to the prospectus and the purpose of the summary is to present the "key information" that investors need in order to be able to decide which offers and admissions of securities to consider further. Summaries should be drafted in plain/clear language, presenting the information in an easily accessible way and ensuring that readers can understand the key information immediately. Issuers should avoid lengthy “boilerplate” text being reproduced in the summary by excessive “copy & pasting”. On the other hand, summaries must be self contained and may not contain cross references to other parts of the prospectus.
With regard to the length of the summary, ESMA proposed that summaries should not exceed 7% of the length of the prospectus or 15 pages, whichever is SHORTER. In the draft Amending Regulation, proposed new Article 24, paragraph 1 of the Prospectus Regulation, provides that the summary shall not exceed 7% of the length of a prospectus or 15 pages, whichever is the LONGER. In any case, this will be a welcome change from the more rigid 2,500 word limit set out in a recital to the Prospectus Directive. However, these limitations may still be an issue particularly in final terms covering multiple products as frequently used in connection with structured note programs.
d) Increased transparency in retail cascades
In its technical advice on Part II of the Mandate, ESMA observes that there is no uniform model of retail cascades within the European financial markets and therefore concludes, with a view to increasing transparency, legal certainty, investor protection and the supervisory needs of competent authorities, that the consent to use a prospectus needs to be included in the prospectus or base prospectus/final terms.
In light of current market practices where the issuer’s ability to identify all financial intermediaries in the prospectus or final terms might be limited, ESMA proposes a two type consent approach consisting of (1) an individual consent approach when financial intermediaries are known to the issuer and (2) a general consent approach when the financial intermediaries are unknown to the issuer. In situations where the issuer knows the identity of only some of the financial intermediaries at the time of approval of the prospectus these are to be included regardless of the use of a general consent approach.
The general consent approach is intended to allow issuers to include in the prospectus a broad consent to any financial intermediary it may concern, whereby issuers consent to the use of a prospectus in writing and the relevant financial intermediaries using the prospectus accept this offer. In the interest of market transparency and investor protection, ESMA requires that any financial intermediary relying on a prospectus previously approved on the basis of a general consent must make public on its own website that it relies for its offer on the prospectus with the consent of the issuer or the person responsible for preparing the prospectus.
In its technical advice, ESMA further sets out certain principles which need to be observed by issuers or persons responsible for the preparation of prospectuses and by financial intermediaries, as well as specifics on the minimum content of the general consent and any conditions attached thereto. ESMA has indicated that it may provide further guidance with regard to these principles and the content of the general consent approach at a later stage.
Although seemingly relatively straightforward in theory, requiring the formal publication (in advance of every offering) by each financial intermediary in a retail cascade of a separate acceptance of each general consent by the relevant issuer for every security sold by that intermediary would appear to create a significant compliance burden for financial intermediaries, which may particularly affect small and medium sized investment advisors which may currently not even maintain their own websites. Some of the larger intermediaries, on the other hand, may in some cases well be required to publish tens of thousands of acceptances on their websites, in particular in the structured notes space. Some commentators have therefore not only challenged the practicability of ESMA's proposal, but also the general premise that the proposed requirement to disclose consents / agreements on use of the prospectus in the prospectus itself helps promote transparency and investor protection in a meaningful way.
e) Indices composed by the issuer
ESMA is concerned about the conflict of interest that exists where an issuer issues derivative securities linked to indices composed by the issuer (proprietary indices). Although disclosure on conflicts of interest is already required, ESMA observes that a description of the relevant indices (including where the index is composed by a third party) in the prospectus (rather than final terms) would provide additional transparency on the issue, ensure that the respective competent authorities have the possibility to scrutinize the description and ensure comprehensibility of the prospectus. A description will be required if the index is composed by the issuer and/or any entity belonging to the same group as the issuer. In addition, there is a presumption of a conflict of interest where an index is composed by an entity acting in association with, or on behalf of, the issuer. If the issuer is able to refute this presumption by including in the prospectus certain statements, the description would not be required.
A number of commentators have appealed to ESMA to continue to permit the inclusion of descriptions of proprietary indices in the final terms to a base prospectus and have argued that there is no proper justification for treating indices composed by the issuer any differently from indices composed and published by third parties.
f) Auditor’s report on profit forecasts and estimates
ESMA proposes to keep the current requirement of an auditor’s report on profit forecasts and estimates as it believes that reports prepared by independent accountants or auditors ensure a certain (minimum) quality of profit forecasts or estimates and provide investors with confidence in those profit forecasts or estimates being prepared on the basis of the underlying assumptions.
With regard to market announcements concerning figures to be published in the next annual audited financial statements in relation to the financial year that has expired, ESMA indicates that a report should not be required if certain criteria are met to ensure the figures are non-misleading and investors are aware of the nature of the included figures.
g) Audited historical financial information
ESMA proposes to keep the current requirement to include three years of audited historical financial information in a prospectus. ESMA believes that a relaxation of the disclosure requirement would result in less extensive information on which investors base their investment decisions and that a relaxed disclosure requirement may be viewed as inappropriate in light of the continuing volatility of global stock markets. A reduction would also result in there being no favourable treatment for SMEs and companies with reduced market capitalisation under the proportionate disclosure regime as proposed in Part I of the technical advice.
As already mentioned above, if adopted by the Commission as currently proposed, some of the proposed changes to the prospectus regime may require significant changes to Prospectus Directive compliant base prospectuses used by numerous issuers in their European debt issuance programs, in particular those base prospectuses used in structured note programs widely used by many financial institutions.
Frequent or continuous issuers, in particular, that have grown to rely on these programs and the ability to issue a wide variety of (often novel) products with very little delay and a great degree of flexibility, are therefore well advised to familiarize themselves with the latest ESMA proposals and the draft Amending Regulation and to consult with their external legal advisers on the potential implications for their programs and the need to review and potentially (significantly) modify existing documentation and previously well-established offering procedures. Specifically, the new proposed regime may cause some market participants in the structured note space to create a larger number of “specialized base prospectuses” or to have recourse to more stand alone prospectuses for particular types of products.
In addition, financial intermediaries and their compliance personnel should start designing procedures as soon as possible to ensure compliance with the proposed consent requirements in the context of retail cascades.