Prospectus regulation

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Prospectus regulation

The coming into force of the Prospectus Regulation represents not just a major change in capital markets regulation, but also the most significant accomplishment to date in the EU's Capital Markets Union (CMU) reform agenda. Once its provisions are fully phased in, it will replace the existing Prospectus Directive regime completely.

Summary

The coming into force of the Prospectus Regulation represents not just a major change in capital markets regulation, but also the most significant accomplishment to date in the EU’s Capital Markets Union reform agenda. However, reactions are mixed among market participants. Will the new framework promote broader participation in Europe’s capital markets?

Prospectus Regulation in force

On July 20, 2017 the Prospectus Regulation (EU) 2017/1129 (PR) came into force. Except for some specific provisions that applied from July 20, 2017 or will apply from July 21, 2018, the bulk of its provisions will apply from July 21, 2019, after which time the existing Prospectus Directive (PD) regime will cease to have effect.

The PR represents a complete overhaul of securities disclosure regulation in Europe, and forms a major part of the EU’s Capital Markets Union (CMU) initiative.

The new regime will not apply retroactively - securities with PD-compliant prospectuses or base prospectuses before the PR fully applies on July 21, 2019 will be grandfathered. In this briefing, we look at the areas where market participants will be most affected.

Convertibles, exchangeables and tap issues

The provisions that applied immediately upon the PR coming into force relate to the exemption from the requirement to publish a prospectus for certain convertible and exchangeable securities.

Under the previous rules, the prospectus requirement for securities that are admitted to trading on regulated markets did not apply to shares resulting from the conversion or exchange of other securities or from the exercise of the rights conferred by other securities, provided that they are of the same class as the shares already admitted to trading. Under the new rules, this exemption is available only where the resulting shares represent less than 20 per cent of the shares of the same class already admitted to trading on the same regulated market.

The PR offers some carve-outs to the 20 per cent cap, including where the convertible securities were listed before the PR came into force or where they are accompanied by their own PD or PR-compliant prospectus. The PR includes a further carve-out for certain instruments issued by financial institutions for regulatory capital purposes (such as contingent convertible bonds).

Also since July 20, 2017 admitting additional securities of the same class on the same regulated market will not trigger the listing requirement for a prospectus, provided that the newly admitted securities are of the same class, trade on the same regulated market and represent less than 20 per cent of the existing ones. This change significantly broadens an old exemption that was limited to equity securities representing a maximum of 10 per cent of outstanding shares.

"Level two" technical standards

In its updated mandate to the European Securities and Markets Authority (ESMA), the European Commission requested advice in respect of possible delegated acts containing level two technical standards that will address in detail the content and procedural requirements and standards under the PR. We expect the technical standards will cover:

Contents of the new universal registration document (URD), which will act as a new form of shelf registration document;
Contents of the PR-compliant prospectus, base prospectus and final terms;
Contents of the new simplified PR-compliant prospectus (to be used for secondary issues);
Contents of the new ‘EU Growth’ prospectus;
Criteria for the scrutiny of prospectuses and the procedures for approval of prospectuses; and
General equivalence criteria for prospectuses drawn up under the laws of countries outside the European Economic Area (EEA).

In respect of timing, the PR requires that the Commission adopts the bulk of necessary level two measures by January 21, 2019. As a result, the Commission has requested advice in respect of third country equivalence criteria no later than 18 months and the other areas mentioned above no later than 13 months following receipt by ESMA of the mandate for technical advice. The mandates were updated on June 1, 2017, so ESMA should deliver to the Commission draft delegated acts in July and December 2018, respectively. ESMA is currently consulting on draft level two measures.

Headline points

Contents of the new universal registration document (URD), which will act as a new form of shelf registration document;
Contents of the PR-compliant prospectus, base prospectus and final terms;
Contents of the new simplified PR-compliant prospectus (to be used for secondary issues);
Contents of the new ‘EU Growth’ prospectus;
Criteria for the scrutiny of prospectuses and the procedures for approval of prospectuses; and
General equivalence criteria for prospectuses drawn up under the laws of countries outside the European Economic Area (EEA).

What’s changing … and what’s not

Retained: €100,000 minimum denomination safe harbor from the prospectus requirement

Currently under the PD, a prospectus is required for offers of securities to the public (the ‘public offer’ trigger), or where securities are admitted to trading on an EEA regulated market (the ‘listing’ trigger). Debt securities issued in denominations greater than €100,000 (or the equivalent in other currencies) are exempt from the ‘public offer’ trigger, although issuers often list on a regulated market anyway, particularly where a prospectus is required under the ‘listing’ trigger. Voluntary listing may be due to investors having investment criteria that require investment in listed securities, or issuers seeking to be exempt from withholding tax in certain Member States.

The PR retains this safe harbor, in addition to other safe harbors from the ‘public offer’ trigger, such as for offers of debt securities solely to qualified investors or to fewer than 150 non-qualified investors or where the total consideration from each investor is less than €100,000.

Changed: minimum issuance thresholds where a prospectus is required

Currently under the PD, issues of securities fall outside the legislation altogether where the total consideration in the EEA is less than €5 million (calculated over 12 months). From July 21, 2018 this threshold will be reduced to €1 million.

While frequent bank issuers will still not need a prospectus for offers of unsubordinated, non-convertible/non-exchangeable debt securities below €75 million (aggregated over 12 months), they will need to rely on exemptions to the ‘public offer’ and ‘listing’ triggers rather than be carved out of the legislation altogether (as is the case under the PD).

From July 21, 2018 Member States will have the discretion to exempt from the prospectus requirement (or instead impose minimum disclosure requirements on) domestic issues of securities with total consideration over 12 months of up to €8 million (up from €5 million). Under this approach, the threshold at which an issue requires a prospectus or other disclosure document depends on whether the issue is cross border or, if domestic, in which jurisdiction, since the threshold will vary according to national law.

Retained: €100,000 distinction between wholesale and retail issues for disclosure purposes

Under the current PD regime, the level of disclosure required depends on whether the prospectus is for a retail or wholesale bond issue. Retail bonds are aimed at a wide base of investors, including less sophisticated investors who regulators consider to be in need of greater regulatory protection. Retail bond issues require a higher level of disclosure than wholesale bond issues, which are issued in minimum denominations of €100,000 and are aimed mainly at institutional investors.

The PR keeps this distinction, and expands the scope of the wholesale disclosure regime to include debt securities trading on a specific segment of a regulated market where only qualified investors can trade them.

Even though the €100,000 denomination exemption may not be strictly necessary to be eligible for the wholesale disclosure regime, issuers may decide to continue to issue in such denomination to avoid financial reporting under the Transparency Directive and registering their auditors under the Statutory Audit Directive. Higher denominations may also appeal to issuers wishing to avoid interest from retail investors (for example, when issuing certain regulatory capital instruments) or to facilitate liability management exercises that may arise later on.

Categorized: risk factors

Under the current rules, prospectuses must set out risk factors relating to the issuer's ability to fulfil its payment obligations under the securities. The threshold for including a risk factor is merely whether the risk is ‘material to making investment decisions’. This approach is also commonly used in the securities offering laws of other jurisdictions.

Under the new rules, issuers will be required to categorize risk factors according to their materiality. Multiple thresholds of risk will need to be established, with procedures put in place to determine what factors to include in each category. ‘Materiality’ in this sense will need to take into account both the likelihood of occurrence and the expected magnitude of the negative impact of such risks. This process will involve quantifying risk in a way that is novel in capital markets regulation.

Issuers are also likely to have some concerns about potential liability issues where risk factors are miscategorized. If an issuer labels a very remote risk as ‘low-risk’ and it then materializes in unusual or unforeseen circumstances, will the issuer or its officers be liable for misrepresentation?

The PR states that an issuer ‘may’ disclose its assessment of the probability of a risk occurring and the gravity of such risk using a qualitative scale of low, medium or high. While use of ‘may’ suggests that this categorization requirement is discretionary, expect issuers and underwriters to continue grappling with these concerns, at least in the short term. The PR empowers the Commission to adopt delegated acts that will hopefully provide some objective criteria for analyzing the materiality of risk factors.

Tightened: prospectus summaries

Transaction summaries were an attempt by PD II to make prospectuses more accessible to investors, but the effect was that the prescribed format was even more difficult to understand. The PR keeps the concept of summaries, but they will be shortened and more prescriptive (subject to extension in certain circumstances).

In terms of when a summary is required, the PR does not require a summary for debt securities trading on a regulated market that either have minimum denominations of €100,000 or are traded on a specific segment of a regulated market that is limited to qualified investors. For note programmes, the obligation to draw up a summary of the base prospectus when the final terms are not included is removed, so that only the ‘issue-specific’ summary is required to be produced and annexed to the final terms when they are filed.

Summaries are changing in terms of content and format. While the page limit is being reduced to seven sides of A4 sized paper, the PR grants discretion to Member States to increase the page limit and substitute content requirements for summaries. This could lead to a patchwork of summary requirements that vary between Member States. On the other hand, some flexibility with respect to page limits may make some jurisdictions more responsive to market needs.

Summaries will need to contain four sections, including:

An introduction containing warnings;
Key information on the issuer;
Key information on the securities; and
Key information on the offer of the securities to the public and/or admission to trading.

Controversially, the PR requires that summaries set out the 15 most material risk factors specific to the issuer, and the guarantor (where the securities are guaranteed). Limiting the number of risk factors in the summary to an arbitrary number is arguably one of the less helpful changes introduced by the PR.

Civil liability will arise in respect of a summary that is misleading, inaccurate or missing material information only when read together with the other parts of the prospectus. Requiring all parts of the prospectus to be read together only protects issuers for claims arising within the EU. There are concerns that issuers could potentially be liable in jurisdictions outside the EU where a material risk factor is in the main prospectus but not the summary.

The format and length are intended to mirror that of ‘key information documents’ (KIDs) that will be required for packaged retail and insurance-based investment products (PRIIPs) under the PRIIPs Regulation from January 2018. In the event that an issue of debt securities is accompanied with a KID, then a prospectus summary will not be necessary. In addition, the PR grants ‘discretion to individual Member States to require a KID in lieu of a prospectus summary.

Introduced: shelf registration disclosure

The PR adopts a disclosure process similar to the North American concept of ‘shelf registration’, which will allow issuers that are listed on a regulated market or multilateral trading facility (MTF) to file an annual URD to be approved even where they do not intend to immediately offer or list securities. URDs will set out all relevant information on the issuer and its business, including some on-going transparency disclosure. Once an issuer has had a URD approved for two years consecutively, it will no longer need prior approval for filing subsequent URDs.

Following acceptance by competent authorities of a URD, approval of prospectuses will be ‘fast-tracked’ for approval by national supervisors. The aim is to shorten approval time for frequent issuers from ten to five working days. In certain circumstances, issuers will be able to fulfil some of their on-going disclosure obligations under the Transparency Directive by integrating their annual and half-yearly financial reports into a URD.

We expect debt issuers to continue using the existing base prospectus format, which acts as a shelf disclosure document for issuance under a note programme. While URDs will be available to use for nearly any kind of debt securities (not only for those issued under an offering programme or in a continuous and repeated way), URD disclosure requirements will be based on the share registration documents plus additional items. As a result, we expect that URDs will be used primarily for equity issuance.

Will it work? This new ‘tripartite’ regime may have teething problems. While a key aim of shelf registration is to allow issuers that have filed URDs to tap the market more quickly, the URD and its amendments need to be usable in prospectuses without further approval steps, which is unclear at the moment. Issuers will be able to take advantage of the fast track approval process, but regulators may still be able to comment on the URD content itself when an issuer files a prospectus.

As long as amendments to the URD filed by frequent issuers can still be reviewed by regulators when a URD is included in a prospectus, the main potential benefit of the URD is negated. In addition, the ability to only file the URD after having had it approved for two consecutive years becomes meaningless if the resulting updated URD cannot be directly used for prospectuses without further approval.

In addition, the PR does not expressly say that URDs also can be passported independently across the EEA. Issuers that decide to file a URD will be required to file it with the competent authority of their home Member State, so it is unlikely that issuers will have URDs filed and approved by multiple competent authorities (as a number of big international banks currently do with base prospectuses). If an issuer were to file a prospectus outside of its home Member State, it is unclear whether the host Member State will be able to comment on the URD separately as part of its prospectus review.

Widened: the range of information that can be incorporated into a prospectus by reference

The PR should reduce duplication of disclosure by widening the range of information that may be incorporated by reference, including:

Information in existing prospectuses, supplements and final terms;
Regulated information under the Transparency Directive and Market Abuse Regulation;
Annual and interim financial information, audit reports and financial statements;
Asset valuation reports; and
Memoranda and articles of association.

When incorporating by reference, issuers will need to include in the prospectus a checklist that cross-refers to such information. When in electronic format, prospectuses will also need to contain hyperlinks to all documents containing information that is incorporated by reference.

Updated: prospectus publication process

Once approved, the prospectus must be made available to the public before the offer to the public or admission to trading takes place. The PR is prescriptive as to what is sufficiently ‘public’. For example, the prospectus must be published on a dedicated section of an easily accessible website, downloadable, printable and searchable in electronic format. Where there is a summary, it must be accessible separately from the prospectus. Access to the prospectus cannot be subject to the completion of a registration process, acceptance of a disclaimer limiting legal liability or payment of a fee.

While arguably this may make publication simpler, it could lead to problems in complying with the offering regimes of third countries. Third countries such as the US, Canada and Australia may take the view that such publication means an offer to the public has been made in that jurisdiction without a listing or registration having been obtained from regulators in that jurisdiction. The effect of this may be to drive some listing activity to MTFs or non-EEA exchanges, where issuers need a listing but not wish to make an offer to the public.

One practical change is the introduction by ESMA of a free and searchable online database containing all prospectuses approved in the EEA and related documents. The intention is to assist consumers in making investment decisions by allowing them to make a more thorough comparison of investment products. Issuers will still be required, however, to provide a free paper copy of the prospectus to anyone who requests it.

Expanded but not simplified: SME disclosure regime

Reforms introduced in 2010 under PD II were intended to increase SME participation in the capital markets by creating a ‘proportionate disclosure’ regime. The alternative disclosure rules were rarely used, however. The PR expands on this concept with a new ‘EU Growth’ prospectus, which targets SMEs that do not have securities trading on a regulated market.

SMEs (i.e. companies with a market capitalization of up to €43 million, turnover of up to €5 million or less than 250 employees) and mid-sized companies with a market capitalization of up to €500 million will be able to take advantage of the lighter disclosure rules, and in either case the maximum size of eligible issues will be €20 million. Larger companies with market capitalizations over these thresholds but that have 499 employees or fewer and are not listed on an MTF will also be able to use an ‘EU Growth’ prospectus for issues up to €20 million.

SMEs that already have securities admitted to trading on a regulated market will not be eligible to use the lighter disclosure rules, in order to avoid a ‘two-tier’ disclosure standard. In other words, investors should be able to review one set of disclosure documents without worrying that there is more comprehensive disclosure available elsewhere. Currently, a prospectus is not required for securities listed on MTFs, provided that they are not offered to the public. This exemption has been retained in the PR.

What information will be required in these minimum disclosure regimes will not be fully known until the draft technical standards (currently under consultation) are finalized. The PR states that at minimum an ‘EU Growth’ prospectus will include a summary, registration document and securities note. The Commission will be empowered to calibrate the growth prospectus disclosure requirements depending on the size of the issuer.

The Commission believes that the ‘EU Growth’ prospectus will be more attractive to SMEs than the proportionate disclosure regime under PD II, because SMEs will be able to passport an approved ‘EU Growth’ prospectus into all EEA Member States. While the ‘EU Growth’ prospectus may be more accessible, it remains to be seen whether a new set of prescriptive rules and prospectus summaries with their tight page limits are in fact ‘user friendly’. Whether the new rules encourage SMEs and others to issue more will depend ultimately on whether the disclosure is in fact lighter.

Simplified: retail cascades and secondary issues

Like the current PD regime, under the new PR a prospectus (or base prospectus) will be valid for up to 12 months for retail cascades provided that it is supplemented and the issuer consents in writing to its use by financial intermediaries for resale.

Issuers will have the discretion to draw up a lighter registration document (called a ‘simplified prospectus’) and securities note for secondary market issuances where its securities have been admitted to trading on a regulated market or SME growth market continuously for at least 18 months and it issues more securities of the same class. Other parties offering existing securities that have traded continuously on a regulated or SME growth market for at least 18 months may also use a simplified prospectus.

Non-EU prospectus equivalence

Timing is everything. Before the UK referendum on exiting the European Union, the European Commission proposed a draft Prospectus Regulation as part of its Capital Market Union (CMU) initiative. Among other things, the proposal contemplated an ‘equivalence’ regime for issuers in third countries that have a prospectus approved by a securities regulator outside of the European Economic Area (EEA).

On December 20, 2016 the European Parliament, Council and Commission agreed on a compromise draft Prospectus Regulation that attaches further conditions to third country equivalence. These conditions were since enshrined in the Prospectus Regulation (EU) 2017/1129 (PR), which came into force on July 20, 2017. While we may never know whether the referendum result inspired these added conditions, we do know that UK issuers should familiarize themselves with the new framework whatever the outcome of Brexit negotiations might be.

Following Brexit, UK issuers may find themselves subject to two separate, but overlapping, sets of disclosure rules. As a result, issuers offering in both the UK and EU may need two separate approvals for its disclosure documents. In such a scenario, it would be more efficient and less expensive if UK issuers could have a prospectus approved by the UK Listing Authority and then rely on an equivalence determination by an EU competent authority to use the same prospectus to offer or list securities in the EU.

The Prospectus Directive 2003/71/EC (PD), which will be repealed as the transitional provision of the PR take effect through to 2019, lacks a single equivalence regime for prospectuses drawn up in accordance with the legislation of third countries, which the European Securities and Markets Authority (ESMA) has acknowledged could hinder cross-border investment flows.

Article 20 of the PD states that the competent authority of the home Member State of a third country issuer may approve a prospectus for an offer to the public or admission to trading on a regulated market, drawn up in accordance with the legislation of a third country, provided that it has been drawn up in accordance with international standards set by international securities commission organizations and the third country’s requirements are ‘equivalent’ to the PD. Generally, the home Member State will either be the Member State where the third country issuer first applies for admission to trading of securities on a regulated market, or the Member State selected by the third country issuer.

Third country equivalence under the current PD will only get you so far. The PD empowers the Commission to adopt, on the advice of ESMA, implementing measures establishing that a country is equivalent for the purposes of Article 20. However, equivalence in this context is not binding on national competent authorities and will not remove a third country issuer’s prospectuses from scrutiny altogether. Rather, it is meant to assist competent authorities of home Member States in their review of third country issuers’ prospectuses.

In February 2016, ESMA issued an opinion stating that the disclosure requirements of Turkey were equivalent. However, the Commission has yet to enact a delegated act establishing equivalence for Turkey. In 2011, ESMA published its framework for third-country equity prospectuses (ESMA/2011/36, revised under ESMA/2013/317) that essentially allows a third country prospectus to have a ‘wrap’ added to it so that the resulting document meets the requirements of the PD. However, this framework has only been applied to one country so far (Israel, in 2015) and, in any event, it is not binding on national competent authorities approving a third country prospectus.

The PD has one limited, equivalence-based exemption from the prospectus requirement, which applies to offers of securities to employees by non-EU issuers whose securities are traded on a third-country market. To benefit from this exemption, issuers need an equivalence decision from the Commission regarding the transparency rule for such third-country market - Directive 2004/109/EC (the Transparency Directive) allows national competent authorities to exempt third country issuers from ongoing disclosure requirements where they deem the laws of the third country to be equivalent.

Under the PR offers of securities to employees will be exempt from the prospectus requirement, regardless of where the issuer is located (i.e. a third country equivalence determination will no longer be necessary for non-EU issuers), provided that a document is made available containing basic information relating to the offer and securities being issued.

More importantly, the PR includes third country equivalence provisions that are akin to Article 20 of the PD. The competent authority of the home Member State of a third country issuer may approve a prospectus for an offer to the public or for admission to trading on a regulated market, drawn up in accordance with the national legislation of the third country issuer.

There are, however, conditions attached. The third-country approved prospectus can be approved for use in the EEA, only if:

the information requirements imposed by that third country legislation are ‘equivalent’ to the requirements in the Prospectus Regulation;
the competent authority of the home Member State has concluded cooperation arrangements with the relevant supervisory authorities of the third country issuer; and
the third country is not blacklisted by the Commission for failing to impose sufficient anti-money laundering and counter-terrorism regimes in respect of its national financial system.

The second condition was added to the compromise text after the Brexit referendum was decided. While a friendly EU competent authority may be keen to sign a cooperation agreement with the UK’s Financial Conduct Authority (the FCA) following Brexit, the compromise text adds safeguards to ensure that the ultimate decision to grant equivalence status rests centrally with ESMA and the Commission.

Firstly, the Prospectus Regulation will empower the Commission to adopt delegated acts setting out general equivalence criteria. The Commission will also have the discretion to adopt implementing decisions determining whether a third country meets the criteria. While not explicitly stated in the Prospectus Regulation, we expect that an implementation decision in respect of the UK will be a necessary first step before an EU competent authority can negotiate a cooperation agreement with the FCA.

In addition, ESMA is mandated to develop level two technical standards that set out the minimum content of the cooperation arrangements to be entered into between the relevant competent authority and the third country supervisor. ESMA will effectively be in a position to erect obstacles to a friendly EU competent authority agreement with the FCA.

Whether the Prospectus Regulation is an improvement over the current regime with respect to third country equivalence will depend on how it is implemented in practice. If, as expected, the UK transposes existing EU rules into national law following Brexit, it should technically be ‘equivalent’ on day one. However, as Brexit negotiations begin, an equivalence determination is expected to be as much a political question as a technical one. If the Commission’s record of finding equivalence for prospectus requirements is anything to go by, then the political question may need to take center stage in on-going Brexit negotiations.