Shearman & Sterling LLP | FinReg | European Supervisory Authorities Issue Guidance on Scope of Application to Bonds of the PRIIPs Regulation
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  • European Supervisory Authorities Issue Guidance on Scope of Application to Bonds of the PRIIPs Regulation

    The Joint Committee of the European Supervisory Authorities has published a Supervisory Statement on the scope of application to bonds of the EU Packaged Retail and Insurance-based Investment Products Regulation. The ESAs have issued the Supervisory Statement in an attempt to avoid the adoption of diverse approaches by national regulators across the EU as to when a Key Information Document is required for different types of bonds under the PRIIPs Regulation. The PRIIPs Regulation, directly applicable across the EU since January 1, 2018, imposes a requirement upon issuers of packaged retail and insurance-based investment products to issue KIDs to retail investors describing key features of their products, in order to enhance transparency and improve investor protection in the PRIIPs market.

    The PRIIPs Regulation has been problematical for bond markets. Although intended as a measure to regulate disclosures on packaged retail products, such as FTSE trackers and insurance-wrapped investments, despite industry comments to the contrary during the consultation and legislative process, European legislators established a very broad and generic definition of PRIIPs, which essentially is likely to include most corporate bonds and most kinds of derivatives. At the same time, the PRIIPs Regulation establishes an onerous disclosure and liability regime, including a requirement for issuers to publish complex risk disclosures in the language of all EU member states where an offering is made. A result of this has been the closure in practice of many bond and derivatives markets to retail investors in Europe, an outcome contrary to that being attempted under the EU's Capital Markets Union project.

    The ESAs raised concerns in July 2018 about the market impact of uncertainty around the scope of the PRIIPs Regulation. In response, the European Commission in May 2019 refused to pass judgement on whether certain categories of products should be deemed to fall within or outside the scope of the PRIIPs Regulation and stressed that the determination of whether an instrument is a packaged retail investment product should be undertaken on a case-by-case basis.

    The Supervisory Statement sets out the ESAs' view of the scope of application of the PRIIPs Regulation to various types of bonds, and follows the recommendations provided to the Commission in their 2018 letter. In particular, their view is that perpetual, subordinated, fixed rate and puttable bonds are out of scope of PRIIPs, but that convertible bonds would be in scope. Bonds with a variable rate would remain in scope. The exemption for sovereigns also remains applicable only for EU sovereign issuers.

    The ESAs' position is more nuanced for variable and callable bonds, as follows:
    • Variable bonds, in which the amount repayable is subject to fluctuations based on the coupon rate, will not always be in scope, depending on the particular features and terms of the bond. Pre-defined increases in the coupon rate not linked to a reference value or the performance of an asset that is not directly purchased should result in the bond not being considered a PRIIP. Bonds that include links to an interest rate index with additional structuring, such as caps or floors, may, on the other hand, fall within the scope of PRIIPs.
    • Bonds with "make-whole" provisions, including callable bonds in which the issuer may redeem the bond prior to maturity, may also not be PRIIPs in all circumstances. This has proved a significant issue in bond market practice, since many bonds include such provisions. Where the amount repayable by the issuer is not fixed, but subject to fluctuations caused by exposure to a reference value, the instrument may be held to be a PRIIP. Similarly, inclusion of a make whole clause that calculated amounts repayable using a reference rate to determine the net present value of future coupon payments may qualify the bond as a PRIIP. The ESAs have stated their view that where the make-whole mechanism used to calculate the discount rate is known to the retail investor in advance, the bond would not fall within the PRIIPs regime. In line with the ESAs guidance, to avoid the PRIIPS regime, the make-whole provisions of offering documents should ensure that the method for calculating the discount rate is known in advance to retail investors. The ESAs guidance does not consider that the investment objectives of an investment should be considered in isolation from the divestment provisions when considering whether a bond is within scope of the PRIIPs Regulation (i.e. the ESAs do not appear to take into account that the term repayable should only refer to the principal investment amount and not to the interest payable on the bond).

    The ESAs recommend that national regulators apply their guidance in supervising compliance with the PRIIPs Regulation. Market practice in bond markets has been to include PRIIPs restrictions on most issuances, often even for deals which are not likely to be in scope. It remains to be seen whether the ESA Supervisory Statement, which is only an opinion of certain supervisory authorities and does not have the force of law of itself, will change such practices.

    The PRIIPs Regulation requires the Commission to undertake a review of the Regulation and the outcome of the review is expected to be published by December 31, 2019.

    View the Supervisory Statement.

    View details of the ESA / Commission correspondence.

    You may like to view our client note, "PRIIPs and Capital Markets Transactions: a Better Way Forward?", April 26, 2018.

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