Bradley Berman, Peter J. Green, Lloyd S. Harmetz, Jeremy C. Jennings-Mares and Anna T. Pinedo
Morrison & Foerster
Over the last few years, we all have become fairly adept at expecting and addressing the unexpected; however, it still remains useful at year-end to consider what’s on the horizon. Here are our thoughts on what to expect in the structured products area in 2014.
The Volcker Rule: Probably the most anticipated (or dreaded) rulemaking, the Volcker Rule was adopted in mid December 2013, but given its heft (about 1,000 pages), market participants are likely to spend many weeks analysing its provisions. Although the Volcker Rule is not specifically focused on structured products, it will have an effect on this market. The rule will limit the ability of financial institutions to maintain inventories in securities, require that financial institutions develop burdensome and complex compliance policies and procedures in order to establish a basis for reliance on the ‘underwriting’ and ‘market-making’ exemptions from the prohibition against proprietary trading, and require that hedging activities be circumscribed in various ways.
Section 621 of the Dodd-Frank Act: This is the neglected ‘step-child’ to the Volcker Rule, which addresses conflicts of interest. Back in 2011, the SEC released a proposed rule (Rule 127B of the Securities Act) to implement the Dodd-Frank provision. The proposed rule would generally prohibit certain persons involved in the structuring, creation and distribution of an asset-backed security from engaging in transactions within one year after the date of the first closing of the sale of such ABS that would involve or result in a material conflict of interest with respect to any investor in such ABS. Depending on the ultimate definition of ‘asset-backed security’ for these purposes, certain structured products may be covered by the rule’s prohibition on conflicts.
Title VII: We recently wrote about the effect of Title VII on the hedges associated with structured product issuances1. The CFTC has finalised most of the rules relating to swaps. We anticipate that we will have greater clarity in 2014 from the SEC relating to the rules applicable to security-based swaps.
CPOs: Although the Staff of the CFTC has provided guidance on various types of vehicles that should not be viewed as commodity pools, it is still necessary to consider each existing or proposed structure that uses a trust or other collective investment vehicle to offer structured products in which the trust engages in swaps activities. The CFTC exemptive relief stops short of addressing trusts that are used to issue credit-linked or insurance-linked notes, so these transactions merit special attention.
Removing References to Ratings: One of the objectives of the Dodd-Frank Act was to ensure that regulations did not incorporate references to credit ratings as that might cause undue reliance by investors and others on ratings. The banking agencies and the SEC have amended many of their rules to eliminate references to ratings; however, this task has not been completed. For example, the SEC has not finalised amendments to Regulation M to eliminate ratings. We discussed the SEC’s proposals in a prior issue2. Depending on the reformulation, this may have an effect on structured products offerings, such as variable price re-offer deals.
Fiduciary Duty: The SEC (and the securities industry) remains focused on finalising the duties of care of broker-dealers. The Dodd-Frank Act required that the SEC consider the appropriateness of imposing a fiduciary duty or heightened duties on broker-dealers. Following discussions regarding the many comment letters submitted to the SEC by industry groups, there is little consensus regarding the types of additional duties that may be imposed on broker-dealers. However, November 2013’s vote of the SEC Investor Advisory Committee to recommend that the SEC adopt fiduciary duties on broker-dealers increases the likelihood of significant changes. In the structured products world, where most of the issuers rely on their affiliated broker-dealers to structure, distribute and hedge notes, and many notes are distributed through proprietary channels, the imposition of a fiduciary duty would have a disparate impact.
Bank Capital and Related Rules: The U.S. banking agencies continue to work to finalise the rules implementing the Basel III framework in the United States. Given that U.S. issuers of structured products are financial institutions subject to the regulatory capital rules, and some buyers of structured products are insurance companies also subject to certain of these rules, the incentives or disincentives created by this framework may have an effect on the market.
FINRA remains keenly focused on the structured products market, and during this past year FINRA has issued various investor alerts and regulatory notices that relate to structured products. In 2014, we anticipate that FINRA will continue to emphasise:
The Importance of KYD: Given that distributors are interacting with retail clients, FINRA has noted that issuers and their affiliated broker-dealers must conduct appropriate diligence of their distributors.
Suitability Determinations and Policies: FINRA has provided additional guidance in the form of FAQs and also its perspective on effective suitability policies. We anticipate that FINRA will pay close attention to the policies and procedures developed by member firms, especially for ‘complex products’.
Conflicts of Interest Policies and Disclosures: FINRA’s recent report on its conflicts of interest review is likely only the first of many communications on this topic. In the report, FINRA advises that it will be monitoring broker activities in this area, and will consider additional regulations, if needed.
Reverse Inquiry: Offerings that begin their lives as reverse inquiry transactions and then are more broadly offered and sold seem to be an area that is under scrutiny.
Heightened Duties in Respect of Complex Products: In all of its communications, FINRA reminds member firms that they have heightened duties when recommending complex products. It is unlikely that FINRA will provide any more detailed guidance, beyond that provided in notice 12-03, on particular products that it views as ‘complex’.
Member firms should review, among other things: (1) Their KYD policies and procedures; (2) their new product approval process to make sure that it addresses issues specific to complex products as well as conflicts of interest; (3) their suitability policies and procedures, as well as training segments that discuss suitability obligations; and (4) ensure that for offerings that started as a reverse inquiry before broadening the offering to include retail investors, there is a process in place to confirm that the offering would be appropriate for a retail investor.
Performance Data: We are hopeful that FINRA will provide guidance on the use of performance data in marketing materials. As we have discussed before3 . FINRA does not permit the use of hypothetical historical index performance data in marketing material; however, this data may be included in ‘issuer materials’. Needless to say, this leads to anomalous results.
144A Data: the SEC has approved FINRA’s rule change to permit the dissemination of trade data through the TRACE system for 144A offerings. It is not clear when this change will take effect, but it may lead to greater transparency for structured product offerings completed on a 144A basis.
Other SEC developments
Above, we mention a number of rulemakings required to be undertaken by the SEC and/or other agencies. In addition to those mandatory rulemakings, we would expect that the SEC will continue to monitor estimated value and other disclosures in structured product offering documents, and in some cases, suggest revisions. We also anticipate that the SEC’s Office of Compliance Inspection and Examinations (OCIE) may ask broker-dealers active in the area about their policies and procedures in calculating estimated value or pricing structured products.
Following a European Parliament vote in November 2013 on the proposed PRIPs regulation, trilogue negotiations between the European Parliament, the Council of the European Union and the European Commission are expected to begin in 2014 under the Greek Presidency of the Council.
The PRIPs regulation is intended to harmonise the disclosure and transparency requirements for the offering of retail investment products (including products issued in the form of securities, fund interests, deposits and life assurance polices) by requiring the production of a short, highly standardised disclosure document (called a ‘Key Information Document’ or ‘KID’) to aid comparison of different products originating from different financial industry sectors.
Following the draft EU Commission Regulation on PRIPs published in July 2012, compromise drafts have been published by the Council and in November 2013, a draft has been approved by the EU Parliament. There are significant differences between the various drafts that need to be addressed in the trilogue.
Of particular focus during the trilogue negotiations will be the following proposals:
scope – the EU Commission and Council draft definitions of ‘investment product’ move away from the requirement for there to be ‘packaging’ of the product but still envisage indirect exposure to some type of underlying asset or index. The EU Parliament draft proposes that investment products generally be in the scope of the definition with an exemption for certain vanilla products.
liability for the KID – this will attach to the product manufacturer (with a possible ‘product seller annex’ containing information for which the product seller will be responsible). Still to be agreed are the burden of proof as to liability and whether this will fall on the investor or the product manufacturer.
length – proposed maximum length of two double-sided A4 pages, plus the seller annex.
content – in addition to the European Commission proposals, suggestions of inclusion of a ‘complexity label’ for complex products, and a link to an online fund calculator for investors to calculate the end value of their investment, after fees and costs. Discussion also as to whether the KID is to be ‘standalone’ or is envisaged as a summary document to be considered in conjunction with a prospectus or other similar document.
other product regulation proposals by the EU Parliament – a product approval process adopted by the manufacturer to ensure compatibility of the product and its target market, new product intervention powers for regulators, a risk management process to be adopted by the manufacturer to measure and monitor the product’s risk profile at any time, restrictions on the structure and methodology of the product’s payoff.
The proposed MiFID II Directive and MiFIR Regulation are currently scheduled to be considered at the EU Parliament’s plenary session to be held between 9 and 12 December 2013.
Most relevant to structured products will be provisions relating to:
increased investor protections
increased product intervention powers for regulators
required exchange trading of certain products deemed sufficiently liquid
greater regulatory capture of different trading venues
pre-trade transparency for traded structured products and derivatives
market access for non-EEA firms for provision of financial services and products
Although parts of the EMIR regulation are already in force, the main provisions relating to compulsory clearing of certain classes of OTC derivatives require further rulemaking and determinations by the European Commission and the European Securities Markets Authority, which are expected during the course of 2014. In addition, the compulsory reporting of derivatives trades to repositories will become effective in February 2014.
This article first appeared in Structured Thoughts (2 December 2013, Volume 4, Issue 14, Page 9 - 12).
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