This article was published on April 3, 2017 by Law 360.
When the European Commission launched its Capital Markets Union (CMU) reform program in 2015, market participants hoped that the initiative would involve a slimming down of regulations.
However, CMU is adding another layer to the existing patchwork of regulations, which has increased steadily since the financial crisis. While unhelpful aspects of regulation have indeed been proposed, a close analysis reveals some benefits as well. The tone taken by EU institutions in respect of CMU has changed since the UK voted to leave the EU. There is a drive towards greater harmonization and regulatory convergence and a more cautious approach to “third-country equivalence” recognition of non-EU regulatory regimes.
Steven Maijoor, chair of the European Securities and Markets Authority (ESMA) has spoken expressly in favour of a comprehensive overhaul of third-country equivalence rules in advance of the effective date of Brexit.
CMU as catch-all for capital markets reform
Rather than a single directive or regulation, Capital Markets Union is a catch-all for a broad variety of initiatives, both regulatory and practical. Underpinning CMU is the European Commission’s aim of addressing a perceived overreliance by corporates in Europe on bank finance, which made them vulnerable during the financial crisis when bank lenders retrenched and tightened their balance sheets.
CMU is intended to reduce or eliminate obstacles to cross-border investment, and to make the capital markets more accessible (especially to small and medium-sized enterprises (SMEs) and infrastructure projects) as an alternative to bank loans.
CMU reforms will affect a wide range of sectors, including credit institutions, investment funds, pension funds, insurance companies and other institutional investors. Non-financial sectors such as energy, infrastructure and transport, as well as SMEs, could potentially benefit from increased investment and competition among finance providers.
One of the earliest and key CMU proposals is a draft new Securitization Regulation, which the Commission hoped would jumpstart post-financial crisis European securitization markets. The draft new Securitization Regulation designates a category of simple, standardized and transparent securitizations to potentially qualify for more relaxed capital rules than other securitizations.
The Commission’s aim is also to make securitization transactions more user-friendly by consolidating the current patchwork of securitization rules into one place. The European Parliament, however, saw this as an opportunity to reign in the securitization industry, which it perceives to be tainted by the financial crisis.
As a result, the progress of the draft new Securitization Regulation has stalled until the Commission and the European Parliament can agree on a common approach.
The draft new prospectus regulation
Significant progress has been made in respect of the second key CMU proposal, the draft new Prospectus Regulation, which is an attempt to address perceived shortcomings in the existing disclosure regime for listed or publicly offered securities. It will replace the existing Prospectus Directive in its entirety when it comes into effect.
Under the current Prospectus Directive, the process of drawing up a prospectus and having it approved by a national competent authority is perceived by issuers as expensive, complex and time-consuming, especially for SMEs.
The draft new Prospectus Regulation also aims to address criticism that prospectuses have become overly long documents that are neither read nor understood by retail investors.
The draft new Prospectus Regulation is approaching the final stages of the legislative process. On Dec. 20, 2016, the European Parliament, Council and Commission formally came to a political compromise as to what the draft legislation will provide for. The compromise text is unlikely to change significantly before it is adopted. The Commission intends for the draft new Prospectus Regulation to enter into force later in 2017, but the majority of its provisions will not apply until 2019.
Throughout the legislative process, there have been a number of improvements from the Commission’s original proposal, although some aspects of the draft new Prospectus Regulation remain more prescriptive than the current rules.
In summary, the issues that have been addressed in the final compromise text include:
- Bonds issued in €100,000 denominations will still be exempt from the “public offer” trigger;
- No prospectus will be required for issues below €1 million;
- The threshold beyond which a prospectus is mandated has increased from €5 million to €8 million, although member states may (individually) require a prospectus for domestic issues of between €1 million and €8 million or establish other disclosure requirements for issues below €8 million, if they enact appropriate domestic laws;
- New carve-outs to the 20 percent cap on exempt securities resulting from the conversion or exchange of other securities have been added, including where the resulting shares are comprised of capital instruments issued by EU-regulated banks, investment firms and insurance or reinsurance firms;
- The wholesale disclosure regime is being retained, along with the €100,000 (or equivalent) denomination threshold, and wholesale bond prospectuses will be exempt from the requirement to produce a prospectus summary;
- The scope of the wholesale disclosure regime will be widened to include issues of debt securities that are admitted to an EU regulated market where access is limited to qualified investors;
- A less onerous “EU Growth” prospectus will be available for SMEs and, in certain cases, larger issuers will also be eligible to use the “EU Growth” prospectus for issues up to €20 million; and
- Lighter disclosure requirements will apply to secondary issuers whose securities are already admitted to an European Economic Area (EEA) regulated market, as well as the SME growth markets, which were created under the Markets in Financial Instruments Directive (MiFID II).
Some unpopular reforms have, however, survived in the compromise text. For example, risk factors will need to be categorised depending on their nature, with the most material risk factors being mentioned first in each category. Summaries may also remain a challenge, as they will be shortened to seven pages and the content requirements will be more prescriptive.
Third-country equivalence for prospectuses
Following Brexit, UK issuers may find themselves subject to two separate, but overlapping, sets of disclosure rules. As a result, issuers offering securities in both the UK and European Economic Area (EEA) may need two separate approvals for their disclosure documents.
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 EEA competent authority to use the same prospectus to offer or list securities in the EEA.
In such a scenario, the Commission’s original proposal contemplated an “equivalence” regime for issuers in third countries that have a prospectus approved by a securities regulator outside of the EEA.
When the European Parliament, Council and Commission agreed on a compromise text of the draft new Prospectus Regulation, however, they attached further conditions to third-country equivalence.
The third country’s legislation will still need to be equivalent, but, unlike the current rules, under the draft new Prospectus Regulation the EEA competent authority will also need to conclude cooperation arrangements with the relevant supervisory authorities of the third-country issuer. The cooperation arrangement condition was added to the draft new Prospectus Regulation after the Brexit referendum in June 2016.
While a friendly EEA competent authority may be keen to sign a cooperation agreement with the FCA following Brexit, the compromise text adds safeguards to ensure that the ultimate decision to grant equivalence status rests centrally with the Commission and ESMA. The draft new 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 draft new Prospectus Regulation, an implementation decision in respect of the UK will likely be a necessary first step before an EEA competent authority can negotiate a cooperation agreement with the FCA.
Under the current regime, an equivalence determination is not binding on EEA competent authorities, and will not remove a third-country issuer’s prospectuses from scrutiny altogether. Rather, it is meant to assist competent authorities in their review of prospectuses. In practice, issuers from potentially equivalent third countries currently enjoy few advantages over issuers from “non-equivalent” third countries.
To date, under the current regime the European Commission has not found a single country to be equivalent for prospectus purposes. In February 2016, ESMA issued an opinion stating that the disclosure requirements of Turkey were equivalent. However, the Commission has yet to establish equivalence for Turkey.
In 2011, ESMA established a framework for third-country equity prospectuses to be “wrapped”, such that the resulting document meets the requirements of the current Prospectus Directive. This has only been applied to one country so far (Israel, in 2015).
Technical Standards to fill in the blanks
While the draft new Prospectus Regulation is largely in final form, it lacks detail in terms of what a prospectus must contain, what level of scrutiny will be required of EEA competent authorities, and what the approval process will consist of.
On Feb. 28, 2017, the Commission requested that ESMA develop technical standards to supplement the draft new Prospectus Regulation and provide these missing details. ESMA is expected to circulate draft technical standards later in 2017.
In its communication to ESMA, the Commission also requested that the technical standards set out the minimum content of the cooperation arrangements to be entered into between the competent authorities of the third country and relevant EEA member states.
As a result, ESMA — and indeed the Commission — will effectively be in a position to erect obstacles to a friendly EEA competent authority agreement with the FCA.
CMU — The medium term
The Commission intends to have a comprehensive package of CMU initiatives in place and implemented by 2019. However, the European Parliament has urged the Commission to put into place a fully integrated single EU capital market no later than 2018.
Currently, the Commission is consulting with stakeholders on whether the CMU program remains fit for purpose. This should inform the Commission’s mid-term review that is scheduled for June 2017.
The Commission’s moves towards greater regulatory convergence and greater harmonization in other areas of CMU will likely result in a greater role for ESMA vis-à-vis EEA competent authorities. It remains to be seen whether over time (post-Brexit) UK rules will diverge, and whether appropriate regulatory and supervisory arrangements can be put in place between the FCA and ESMA.
If, as expected, the UK transposes existing EU rules into national law immediately 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 any Brexit negotiations.
Whether the draft new Prospectus Regulation is an improvement over the current Prospectus Directive regime with respect to third-country equivalence will depend on how it is implemented in practice.
The success of this project will ultimately depend on the level of buy-in by investors, issuers and the capital markets industry as a whole, as it is vitally important to ensure that the regulatory framework for capital markets remains competitive in relation to the rest of the world.
It is hoped that the Commission and ESMA will bear this in mind, even as they shift the CMU project towards greater EU centralisation.