Structured Thoughts: Volume 5, Issue 9 December 23, 2014 - Commodities/Derivatives/Stock Exchanges

What to Expect in 2015?

Here are our thoughts on what to expect in the structured products area in 2015.

Dodd-Frank-Related Developments

The Volcker Rule: Last year at about this time in December, we were still working our way through the final Volcker Rule. A year has passed and we are still attempting to understand the exceptions that may be available in connection with hedging of exposures arising in connection with the issuance of structured products. We anticipate that there will be additional regulatory guidance on the Volcker Rule. In fact, in their public statements, Federal Reserve representatives have alluded to possible changes relating to the metrics and compliance policy requirements. We anticipate that market participants will continue to work diligently to formulate compliance policies and procedures designed to address the hedging activities in relation to structured products, as well as their market making activities.

Section 621 of the Dodd-Frank Act: Since the SEC released a proposed rule in 2011 (Rule 127B of the Securities Act) to implement this Dodd-Frank provision, there has been no further activity. The 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. As we noted in our last year's recap, 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: At this stage, market participants already have adopted approaches to address their hedging activities related to structured products, to the extent that in hedging, "swaps" are used. We still await final SEC rules relating to securitybased swaps.

CPOs: During 2014, the Staff of the CFTC has provided additional relief to various types of vehicles that, in the absence of such guidance, may have been viewed as commodity pools. However, the CFTC exemptive relief does not address trusts used to issue credit-linked or insurance-linked notes, so these transactions merit special attention.

Volcker Covered Funds: Similarly, any trust or similar passive vehicle used to "repackage" bonds should be closely examined as it may be a "covered fund" for purposes of the Volcker Rule.

Removing References to Ratings: As we noted in last year's round-up, 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 SEC has not finalized amendments to Regulation M to eliminate ratings. Depending on the reformulation, this may have an effect on structured products offerings, such as variable price re-offer deals.

Fiduciary Duty: Recent statements made by representatives of the SEC suggest that the imposition of a fiduciary duty is still being considered closely, although the timing is uncertain.

Bank Capital and Related Rules: The principal elements of the Basel III framework were implemented in the United States in July 2013. In 2014, the banking agencies implemented a final liquidity coverage ratio and a final supplemental leverage ratio for the largest banks. In addition, the banking agencies have proposed a capital surcharge for the largest banks. In the meantime, the BCBS has completed its work on the net stable funding ratio framework and the Financial Stability Board has outlined a proposal relating to TLAC, or total loss absorbing capacity. Given that financial institutions are the principal US issuers of structured products, it can be expected that as banks begin to address the cumulative effect of these capital and liquidity measures, their perspective on the types of financial instruments they issue may change. Also, rating agencies likely will continue to refine their ratings assessment of financial institutions based on regulatory changes, and this may affect pricing.

FINRA Developments

It has been a relatively quiet year in the sense that FINRA has not issued any investor alerts or regulatory notices related principally to structured products. This should not be viewed as any indication that FINRA has lost its interest in, or focus on, structured products. As representatives of FINRA have made clear in their public remarks, FINRA continues to watch this segment of the market closely. We anticipate that FINRA will continue to monitor how member firms approach:

Complex Products: FINRA representatives have noted that they are particularly interested in the policies and procedures that firms have implemented relating to vetting new products that may be deemed complex products, as well as conducting post-sale reviews of such products.

KYD: FINRA representatives have addressed the types of diligence inquiries that "manufacturers" of structured products should undertake in connection with distributors of these products.

Conflicts of Interest Policies and Disclosures: FINRA remains focused on the policies and procedures that member firms implement in order to address conflicts of interest. In the structured products area, FINRA has focused on: conflicts that may arise as a result of the various roles that legal entities within a financial institution may play in the context of a structured product issuance (e.g., issuer, affiliated broker-dealer as underwriter, related party as calculation agent, etc.), conflicts that may arise where brokers are compensated differently in relation to sales of structured products, actual or potential conflicts arising in connection with any proprietary index used as a reference asset, etc.

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.

Performance Data or "Hypothetical Backtested Data": FINRA continues to raise concerns that retail investors place undue reliance on hypothetical backtested data used in marketing materials. Of course, this type of information can be used in issuer-prepared materials filed with the SEC. We anticipate that the discussion on backtested data will continue given that many European regulators expressly require such data to be produced and shared with investors.

Other Developments

Benchmark Indices: European regulators and IOSCO remain focused on the potential issues relating to "benchmark indices." Although European legislation regulating benchmark indices has not been adopted yet, both ESMA/EBA and IOSCO have released their principles and global institutions should review their indices in light of these best practices.

Disclosure Reform: the SEC Staff has been undertaking a review of current disclosure requirements. We are hopeful that, as a result of this process and dialogue relating to streamlining disclosure to make it more investor-friendly and accessible, we will have an opportunity in the future to revisit many of the lengthy disclosures that have become a fixture in the structured products market.

EU Regulatory Agenda: Into 2015

2014 was an active year for financial regulation in the EU with a push to finalize much of the outstanding primary legislation on the regulatory reform agenda in advance of the European Parliamentary elections in May 2014. This resulted in the adoption of many EU Regulations and Directives in the first half of the year. There is still, however, some outstanding legislation still going through the EU legislative process, and much of the legislation that has been adopted envisages further legislation and regulation in the form of delegated regulations to be adopted by the EU Commission comprising technical standards to be drafted by the European Supervisory Authorities (the "ESAs")¹. We have set out below the likely key areas of activity during 2015.

Derivatives Reporting. The European Market Infrastructure Regulation ("EMIR"), providing for the regulation of derivatives in the EU, has been in force since 2012 but many of the key provisions are only now beginning to come into effect. Rules requiring reporting of derivative transactions to trade repositories started to be phased in from February 2014 and are now largely implemented. There were, however, some difficulties in implementation of the rules which represented a logistical and administrative challenge for many market participants. Many of these issues have now been resolved, but in November 2014 ESMA proposed various changes to the relevant technical standards to seek to resolve certain issues. It is therefore likely that there will be some technical amendments to the derivatives reporting regime in early 2015.

Derivatives Clearing. Provisions in EMIR requiring the central clearing of many OTC derivatives are not yet in operation, but the implementation process is well underway. In 2014 ESMA published a number of draft technical standards setting out the initial classes of derivatives it proposes be subject to the clearing obligation, including many vanilla interest rate derivatives, credit derivatives referencing certain untranched credit indices and some non-deliverable fx forwards. ESMA proposes a phase-in for the clearing obligation based on four categorizations of counterparties with the largest and most active market participants being required to clear first. Category 1 entities will be required to clear transactions six months after the date the applicable technical standards come into force, which means such entities are likely to be subject to the clearing obligation for relevant derivatives from around August 2015.

Derivatives – Collateralization of Uncleared Transactions. In April 2014, the ESAs published technical standards on risk mitigation techniques for the collateralization of uncleared derivatives transactions. The proposals included the collection of both variation margin during the life of the transaction and initial margin upon inception of the trade. Assets provided as collateral are subject to eligibility criteria. Once received, margin must be segregated from proprietary assets of the relevant custodian, and initial margin cannot be rehypothecated. The collateralization of uncleared trades will be phased in from December 1, 2015, although only the largest market participants (those trading non-centrally cleared derivatives in excess of €3 trillion in monthly aggregate notional amount) will initially be subject to the rules. All counterparties trading such derivatives in excess of €8 billion will be subject to the requirements by December 2019.

MiFID II. MiFID II is the overhaul of the Markets in Financial Instruments Directive and comprises a Regulation ("MiFIR") and recast Directive. It came into force in August 2014 but does not become effective until January 2017. ESMA is due to publish many draft technical standards during 2015, including in relation to provisions relating to investor protection, market infrastructure, exchange trading of derivatives and pre and post-trade transparency requirements for bonds, structured finance instruments and derivatives traded on a trading venue. ESMA published a Consultation Paper and a Discussion Paper in July 2014 outlining its initial views, and a second consultation paper is expected in December 2014.

PRIIPs. The Regulation on key information documents ("KIDs") for packaged retail and insurance-based investment products ("PRIIPs") comes into force on December 29, 2014, although it does not become effective until December 2016. When a person is advising on or selling a PRIIP to retail investors, a pre-contract KID must be provided to the investor. The Regulation contains detailed requirements as to the form and content of the KID. In November 2014, the ESAs released a joint discussion paper setting out their thoughts as to the presentation and content of each element of the KID content and other matters including the methodology underpinning the presentation of risk and reward. The ESAs are expected to publish a consultation on draft technical standards and a further technical discussion paper during 2015.

Benchmark Regulation. The use of benchmarks in financial transactions has been in focus in recent years following alleged misconduct in relation to the setting of LIBOR and other financial benchmarks. In July 2013, the International Organization of Securities Commissions ("IOSCO") published principles for financial benchmarks, and in September 2013 the EU Commission published a draft regulation in relation to indices used as benchmarks in financial instruments and contracts, which seeks to impose various obligations on benchmark administrators, contributors and users. Administrators located in the EU will be subject to authorization and supervision by their competent authorities and be subject to detailed governance and reporting requirements. The legislative process will continue into 2015, and there are likely to be considerable efforts to finalize the Regulation during the year.

BRRD / Bail-in. Under the Bank Recovery and Resolution Directive (the "BRRD"), unsecured structured notes and other structured products issued by a bank will be liable to be written off or converted into equity instruments by a national resolution authority if the bank enters into resolution. Such authority will also be able to terminate and close out derivatives contracts of an EU bank as part of the resolution process and bail-in the resulting net liability. These concepts are consistent with the "Key Attributes of Effective Resolution Regimes for Financial Institutions" updated by the Financial Stability Board ("FSB") in October 2014. Surprisingly, the FSB has proposed that structured notes will not be counted towards the required minimum levels of bail-inable liabilities that it recommends a global systemically important bank must maintain. There is likely to be further discussion on this issue into 2015.

Structural Banking Reform. Based on the current proposed form of the EU Bank Structural Reform Regulation, the structured products and related activities of in-scope entities should not constitute prohibited proprietary trading, due to their connection to actual or anticipated client activity. However, in-scope entities that accept insured deposits will remain subject to the possibility of being forced to separate off structured products or other activities, if their national competent authority decides that the activities pose a threat to the financial stability of the institution or the EU financial system as a whole. The draft Regulation is still in the early stages of the EU legislative process and is subject to further debate and negotiation during 2015. Banking Reform Act in the UK. In the UK, it looks likely that a ring-fenced bank (broadly, a bank engaging in significant non-institutional deposit-taking) will not be permitted to sell structured products or derivatives unless they fall within a specified range of hedging transactions for customers. In addition, it seems that neither their subsidiaries, nor their parent companies will be able to engage in such activities, and banking groups that contain a ring-fenced bank will need to engage in these activities through "sibling" entities. These proposals are controversial and likely to be subject to further debate into 2015. The ring-fence will not come into force until 2019, but banks are already planning the transition to the new regime.

AIFMD. The Alternative Investment Fund Managers Directive ("AIFMD") came into effect in July 2013 and governs the management and marketing of alternative investment funds ("AIFs") by Alternative Investment Fund Managers ("AIFMs") in the EU. Non-EU AIFMs marketing one or more AIFs to professional investors in an EU country are currently required to comply with that country's AIFMD implementing legislation irrespective of the domicile of such AIFs. However, such non EU AIFMs cannot benefit from the AIFMD marketing passport across the EU until the European Commission implements delegated legislation extending the passporting regime to non-EU AIFMs (following a positive opinion from ESMA). This is expected to be in place by the end of 2015 but until then non-EU AIFMs can only actively market AIFs to professional investors in the EU in accordance with the relevant national private placement regime.

Financial Transactions Tax. Despite lack of support for an EU-wide financial transactions tax ("FTT"), 11 Member States² are proceeding with proposals to harmonize legislation on the indirect taxation of financial transactions with a tax of 0.1% on all transactions relating to financial instruments other than derivatives which will attract a tax rate of 0.01% on the notional amount of the transaction. The UK challenged the proposals based upon, among other things, their potential extraterritorial effect but this was rejected by the European Court of Justice, at least for the time being. The legislative process somewhat stalled during 2014 but the EU Council indicated in November 2014 that work will be intensified amongst the relevant member states during 2015. Further legislative proposals are likely sometime in the New Year.

UCITS V. The UCITS V Directive came into force in September 2014, and EU member states have until 18 March 2016 to transpose it into their national laws. It makes various changes to the existing UCITS Directive, principally seeking to make provisions relating to depositaries and remuneration rules for management companies more consistent with those applicable to AIFs under the AIFMD. A number of delegated acts and technical standards must be adopted by the EU Commission, and ESMA has published technical advice, including in relation to insolvency protection of the assets of a UCITS when the depositary has delegated safekeeping duties to a third party and the requirements on the management company and depositary to act independently. The EU Commission is likely to finalize the delegated acts during 2015.

FINRA Issues Report Relating to its Communication Rules

FINRA's communications rules affect the content, required approvals and potential filings of broker-dealer communications relating to structured products³. FINRA's 2013 amendments to the communications rules had specific applications to this market, resulting in a variety of changes to the offering process for many structured notes.

In April 2014, FINRA launched a review of its communications rules, as part of an ongoing initiative "to periodically look back at significant groups of rules to ensure they remain relevant and appropriately designed to achieve their objectives, particularly in light of industry and market changes." The review involved discussions with, and written comment submissions by, a wide variety of market participants⁴. In December 2014, FINRA issued its report regarding its review⁵. The report describes the responses of market participants and the potential nature of FINRA's planned rulemaking process. This process may result in changes to the communications rules that would affect the structured products industry.

FINRA Filing Requirement

The 2013 amendments to the communications rules required the filing with FINRA of certain types of materials used in connection with registered public offerings of structured notes. According to the report, many respondents believe that the filing requirements are overbroad in some respects relative to the investor protection they provide. They stated that the filing requirements impose significant direct and indirect costs on firms, and potentially divert FINRA resources from higher-risk matters. Some firms also indicated that the high volume of materials filed with FINRA has resulted in a backlog of filings to be reviewed; stakeholders also expressed some frustration with the turnaround times for review of communications, and encouraged FINRA to explore ways to make more efficient use of its review resources⁶. Many broker-dealers suggested that a risk-based approach to filing would be a better use of both broker-dealer and FINRA resources.

Contents and Length of Disclosures

Rule 2210(d) requires disclosures in retail communications to be "fair and balanced," and not misleading. But of course, in connection with most marketing materials, there are judgments to be made as to what that standard means, and how it should be applied. In connection with its comment process, the FINRA Advertising Department has often requested that broker-dealers expand the content of these documents, particularly with respect to risk factors.

As a result, FINRA indicated in the report that market participants asserted that the amount of required disclosure has become disproportionate to the substance of marketing materials, reducing the value of these materials to investors and potentially giving the impression that the risks of an investment outweigh its benefits. Some also asserted that the FINRA staff expects almost as much risk disclosure in sales material as is contained in the statutory prospectus for the relevant offerings. They further stated that FINRA's staff interpretations of the content standards do not allow for layered disclosure (such as hyperlinks or references to other sources of information or offering documents), which would be more efficient and effective. They also asserted that these disclosure requirements discourage materials that would educate investors about strategies (e.g., diversification), products, services, fees and expenses.

To date, FINRA has also restricted the use of some types of information, particularly back-tested performance information as to proprietary indices and strategies, in materials intended for retail investors. Accordingly, many respondents favored more permissive use of this type of information.

Clarity and Transparency of FINRA Reviews

According to the report, market participants asserted that the principles-based content standards of the communications rules lead to a variety of challenges. Some asserted that the key content standards—e.g., "principles of fair dealing," "fair and balanced," "exaggerated" and "unwarranted"—are too subjective. While they indicated that FINRA's guidance to date has been helpful, they generally suggested that this type of guidance needs to be more frequent, and needs to capture the Advertising Department's comments in a consolidated way. For example, unlike in most SEC comment letters to issuers, there is no public source of information for FINRA's comments, or for the guidance contained in those comments.

Similarly, each broker-dealer has its own assigned reviewer, and it is possible that different reviewers have different opinions and judgments as to these disclosures. Accordingly, some commenters expressed the view that analyst reviews could be performed in a more consistent manner.

Expense of Reviews

Commenters asserted that the direct costs of filing and re-filing, including expedited filing fees when a broker ceases to use materials quickly, can be significant. Many firms also indicated that the indirect costs associated with filing and refiling exceed those direct costs-- most significantly, the personnel and technology resources needed for the compliance functions required by the rules. One person asserted that the rules are anticompetitive, because they make FINRA a "marketing partner for firms" that file materials and pay a fee to have their communications reviewed.

Conclusion

FINRA believes that its review demonstrates widespread agreement among affected parties that its communications rules "have been largely effective in meeting their intended investor protection objectives. However, the rules and FINRA's administration of them may benefit from some updating and recalibration to better align the investor protection benefits and the economic impacts."

With particular relevance to structured products, according to the report, FINRA's staff recommends the initial consideration of:

aligning FINRA's filing requirements and review process with the relative risk of the communications;
facilitating simplified and more effective risk disclosure; and
providing more guidance regarding application the of FINRA's content standards, including exploring the adoption of comprehensive performance standards.

Over the next several months, FINRA expects to explore a combination of guidance, proposed rule modifications and administrative measures to enhance the effectiveness and efficiency of the rules. In the upcoming action phase, FINRA will engage in its typical rulemaking process to propose any amendments to the rules based on the assessments.

Footnotes

1 The ESAs comprise the European Securities and Markets Authority ("ESMA"), the European Banking Authority (the "EBA") and the European Insurance and Occupational Pension Authority ("EIOPA").

2 Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia and Slovakia

3 The communications rules consist of FINRA Rule 2210 (which is generally most relevant to structured products) and Rules 2212-2216.

4 FINRA invited public comment in its Regulatory Notice 14-14: https://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p479810.pdf .

5 The report may be found at the following link: http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p602011.pdf .

6 If you have tried recently (for example) to have a financial institution's proposed structured products website reviewed by FINRA, it is possible that you share that view.

To view the full newsletter please click here.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.