PRIPs - Key Information Documents for packaged retail investment products

On 3 July 2012, the European Commission (the Commission) published three legislative proposals which are designed to increase consumer protection in financial services. The first legislative proposal is a draft Directive which amends the UCITS Directive and introduces text that is intended to strengthen the obligations and responsibility of depositaries. The second legislative proposal seeks to recast the Insurance Mediation Directive, which regulates access to, and the exercise of, insurance and reinsurance mediation activities. The third proposal is a draft Regulation which concerns packaged retail investment products (PRIPs) and establishes the requirement of a key information document (KID).

In this briefing note we focus on the Commission’s proposals for PRIPs.

The launch of the legislative proposals signalled the Commission’s intention to place the retail investor at the heart of EU financial services regulation. Internal Market and Services Commissioner Michel Barnier said: "In the aftermath of the biggest financial crisis in recent memory, the financial sector must place consumers at its heart. Retail products must be safer, information standards must become clearer, and those selling products must always be subject to the highest standards. That is why we have adopted a package solely dedicated to consumers, so that they can choose financial products based on clear and sound information and professional advice which puts the consumer's interests first."

In relation to PRIPs the Commission’s rationale for introducing the proposals can be found in the explanatory memorandum to the draft Regulation (from hereon the draft Regulation is referred to as the Regulation). In the explanatory memorandum the Commission explains that within the EU existing disclosures currently vary according to the legal form a product takes, rather than its economic nature or the risks it raises for retail investors. The comparability, comprehensibility and presentation of information varies so much that the average retail investor struggles to make any meaningful comparisons between products.

The Commission feels that the importance of dealing with these issues has been highlighted by the financial crisis which has seen retail investors lose money with investments that carried risks that were not transparent or understood by those investors. It believes that improving the transparency of products, taking into account the needs of retail investors, is an important part of rebuilding confidence in the EU financial services industry.

The Commission’s proposal on PRIPs is therefore about improving transparency in the investment market for retail investors. Transparency is to be improved through the introduction of the KID.

The Commission has been working on the proposal for PRIPs for some time. The genesis of the proposal is the request from the ECOFIN Council in May 2007 for the Commission to examine the coherence of EU law applying to different types of retail investment products.

The first stage of the Commission’s work culminated in the adoption of a Communication on Packaged Retail Investment Products in April 2009. The Communication noted that there were two areas of work covering rules applying to sales, and rules on product disclosures. The Commission’s current proposal derives from the latter work stream on product disclosures.

In relation to the other work stream the explanatory memorandum to the Regulation gives little away except to state that the legislation is dedicated to retail investor disclosures and that it does “not address other rights or obligations of product manufacturers, persons selling investment products or investors where a Directive might be the appropriate legal form.”

The Commission’s proposal takes the form of a Regulation which will be directly applicable to Member States. The Regulation sets out the overall principles on the approach and content of the KID. However, there are a number of questions that the Regulation raises and many of these will only be answered when drafts of the supporting detailed delegated/implementing acts are published. The delegated/implementing acts will ultimately form a package with the Regulation and standardise the information that is required.

When the Commission published the proposals it also produced an impact assessment. However, there has been some criticism in the market already that the Commission failed to set out clearly in this document how different financial sectors would be affected by the proposals.

Article 1 of the Regulation deals with scope and provides that:

“This Regulation lays down uniform rules on the format and content of the key information document to be drawn up by investment product manufacturers and uniform rules on the provision of this document to retail investors.”

For the purposes of the Regulation a “retail investor” means a retail investor as defined under the Markets in Financial Instruments Directive or a customer within the meaning of the Insurance Mediation Directive.

A key term used throughout the Regulation is “investment product” and this is defined in article 4 of the Regulation as:

“an investment where regardless of the legal form of the investment the amount repayable to the investor is exposed to fluctuations in reference values or in the performance of one or more assets which are not directly purchased by the investor.”

An important point to note about the “investment product” definition is that it does not include any reference to a product being intended for retail use. This is on the basis that the Commission believes that the retail element may only be determined at the point of sale, when the distributor sells a certain investment product to a retail investor, or provides advice on it. Also the mechanisms by which payouts are made are also not relevant.

Another important point to note concerning the definition of “investment product” is the second limb which focuses on packaging through a reference to the indirectness of holdings of assets. Such a definition would include products with capital guarantees, and those where, in addition to capital, a proportion of the return is also guaranteed; investment funds, whether closed-ended or open-ended; all structured products, whatever their form (for example packaged as insurance policies, funds, securities or banking products) and insurance products whose surrender values are determined indirectly by returns on the insurance companies own investments.

Article 2 of the Regulation sets out certain products that are outside scope and these include:

• products where the precise rate of return is set in advance for the entire life of the product;
• plain shares and bonds, insofar as these do not contain a mechanism other than a direct holding of the relevant assets;
• deposits with a rate of return that is determined in relation to an interest rate;
• insurance products that only offer insurance benefits (such as pure protection insurance products or non-life products) which provide no surrender value that is exposed to fluctuations in the performance of one or more underlying assets or reference values;
• occupational pension schemes covered by Directive 2003/41/EC or Directive 2009/138/EC; and
• pension products for which a financial contribution from the employer is required by national law and where the employee has no choice as to the pension product provider.

Article 5 of the Regulation provides that the “investment product manufacturer” is the party that is required to draw up a KID. The investment product manufacturer must produce a KID for each investment product it produces.

Article 4 defines an investment product manufacturer as:

“any natural or legal person who manufactures an investment product; and any natural or legal person who makes changes to an existing investment product by altering its risk and reward profile or the costs associated with an investment in the investment product.”

There is some guidance in the explanatory memorandum to the Regulation concerning the meaning of investment product manufacturer. The explanatory memorandum states that this is the person who produces an investment product but also a person who has “substantively” changed the risk or cost structure of an existing investment product. Whilst this recognises that not every change to the original investment product will trigger a shift of responsibility it does leave open the question as to what exactly are substantive changes.

A further interesting point that the explanatory memorandum mentions is in relation to investment product manufacturers collaborating with distributors. It states that: “Delegation of the preparation of a part or the whole disclosure to third parties, such as may occur under collaboration with distributors, has no impact on the overall responsibility of the product manufacturer with regard to the KID.”

Articles 6 to 9 of the Regulation cover the form and content of the KID.

Two fundamental concepts are contained in articles 6(1) and 6(2) in that the KID must be accurate, fair, clear and not misleading. It must also be a stand alone document, clearly separate from marketing materials. The remainder of article 6 then sets out certain qualitative requirements such as the KID should be set out in a way that is easy to read and the language used is clear, succinct and comprehensible.

Article 7 then provides that the KID must be in the official language or one of the official languages of the Member State where the investment product is sold. Article 8 provides for set wording that must appear on the first page of the KID. This article then adds certain quantitative information that must appear in the KID such as the type and term of the investment product and its objectives and the means of achieving them. The article also provides for the KID to introduce a number of specific sections including those entitled “Could I lose money” (a brief indication of whether loss of capital is possible) and “What are the costs” (information on the direct and indirect costs to be borne by the retail investor). There are a number of questions which arise when reviewing article 8. For instance precisely what counts as “indirect costs” and what degree of costs breakdown is required. These questions will only be answered when we see further information which will be set out in delegated/implementing acts.

The scope for product manufacturers to provide additional information in the KID which is not prescribed by the Regulation is limited. Article 8(3) of the Regulation provides that such information may only be provided where “it is necessary for the retail investor to take an informed decision about a specific investment product.”

Many in the market have already pointed out that investment product manufacturers should not underestimate the difficultly in reducing complex concepts into plain language and short form.

Article 10 of the Regulation contains the general principle that an investment product manufacturer should review the KID regularly and revise it where such review indicates that changes should be made. Delegated/implementing acts will provide further information concerning when and how the KID should be reviewed.

Articles 12 and 13 of the Regulation deal with when and how a KID should be provided to a retail investor. The general principle in article 12(1) is that the KID is to be provided in “good time” before the conclusion of the transaction. However, article 12(2) provides derogation from this principle and the KID may be provided “immediately” after the conclusion of the transaction where:

• the retail investor chooses to conclude the transaction using distance communication;
• the provision of the KID in good time is not possible; and
• the person selling the investment product has informed the retail investor of this fact.

Further information concerning both concepts will be set out in delegated/implementing acts.

Article 13 sets out how the KID should be provided to the retail investor. The key principle is that the provision of the KID should be free and involve one of the following media:

• on paper;
• subject to the conditions set out in article 13(4) on another durable medium other than paper; or
• subject to the conditions set out in article 13(5) by means of a website.

However, if the KID is being provided in a medium other than paper then, in addition to the conditions mentioned above, article 13(6) adds the further requirement that there must be evidence that the retail investor has access to the internet. The provision by the retail investor of an e-mail address shall be regarded as such evidence.

Some in the market have mentioned that investment product manufacturers should not underestimate the volume of KIDs that will need to be produced or the resources that will need to be used to produce them by the required deadline.

High level requirements concerning the investment product manufacturer’s liability are set out in article 11 of the Regulation.

Where an investment product manufacturer has produced a KID which does not comply with the requirements of articles 6, 7 and 8 of the Regulation on which a retail investor has relied when making an investment decision, such a retail investor may claim from the investment product manufacturer damages for any loss caused. Where a retail investor demonstrates loss resulting from the use of the deficient KID the burden of proof is on the investment product manufacturer to prove that the KID has been drawn up in compliance with articles 6, 7 and 8 of the Regulation. It is worth noting that the burden of proof cannot be altered in advance through an agreement. Any such clause in an agreement will not be binding.

Investment product manufacturers will be concerned about their potential liability for the deficiencies in their KID. In light of this a great deal of care will need to be taken when drafting a KID and this will mean a further draw on resources.

Some in the market have argued that limited liability as provided in article 79.2 of the UCITS IV Directive should be included in the Regulation. They argue that the liability on a KID needs to be limited because this document cannot and should not include all the information on the financial product.

Articles 14 to 17 of the Regulation cover complaints, redress and cooperation. This includes measures which are intended to ensure effective complaints procedures both on the part of the investment product manufacturer and at the level of Member States.

Articles 18 to 22 contain provisions on sanctions and measures aimed at introducing a harmonised approach in order to ensure consistency.

The UCITS IV Directive introduced the key investor information document (KIID) for UCITS. In light of this the Commission feels that at this stage it would not be proportionate to apply the Regulation to UCITS. For this reason articles 23 to 24 of the Regulation introduce transitional provisions. These provisions allow UCITS to continue to use the KIID in accordance with the UCITS Directive for five years following the Regulation’s entry into force.

Article 25 of the Regulation is a review clause which provides that the Commission will review the effectiveness of the Regulation after four years following its entry into force. This is timed to coincide with the end of the transitional period for UCITS so that a conclusion can be drawn on the appropriate treatment of UCITS. The Commission also mentions in the recitals to the Regulation that such a review should also cover whether or not the scope of the Regulation should be broadened to cover new or innovative investment products being offered in the EU.

The Commission believes that the design and purpose of the KID are not fully identical with certain other disclosure requirements such as the summary under the Prospectus Directive or disclosure requirements under Solvency II. The Commission argues that these disclosures seek to fulfil purposes in addition to the delivery of key information to retail investors, such as ensuring transparency towards financial markets or a full picture of all details in relation to a proposed contract. In light of this the Commission feels that the KID cannot easily replace these other requirements and will exist in parallel with them.

The proposal has now gone to the European Parliament and the Council of the European Union for their consideration under the co-decision procedure. Once they reach agreement further work will be done by the Commission on the implementing measures.

However, the proposal may be extensively amended whilst in the European Parliament. The MEP in charge of the proposal for the European Parliament, Pervenche Berès, has stated that it goes “in the right direction but we need to go further.” She has called for a regulatory framework that defines the PRIPs that can be sold to small investors, in other words, provisions that regulate the investment products themselves. She stated:

“The protection of European investors cannot be limited to transmitting exhaustive information that is often virtually incomprehensible to most people. Giving small investors better information will not be enough to help them make the best choices.” She is therefore proposing the introduction of a “regulatory framework for financial products identifying those that can or cannot be sold to small investors.”