Distributing cocos - new temporary rules from 1 October 2014

Some contingent convertible instruments (cocos) will be subject to new temporary product intervention rules from 1 October 2014. Alexandria Carr, financial services and regulatory Of Counsel at Mayer Brown, explains who will be affected and suggests that concerns over cocos may prompt wider European action.

Original news

Firms will be restricted from distributing cocos to the mass retail market after 1 October 2014, the Financial Conduct Authority (FCA) has announced. As cocos are highly complex, the FCA believes they are unlikely to be appropriate for this market, so has used its new consumer protection powers to place a temporary restriction on their distribution ahead of consulting on permanent rules later in 2014.

What is the background to the temporary product intervention rules?

When the FCA was established on 1 April 2013, it was given a new power to make product intervention rules. This power is set out in the Financial Services and Markets Act 2000, s 137(D) (FSMA 2000), as amended by the Financial Services Act 2012. FSMA 2000, s 138M provides that the FCA may make product intervention rules without consultation (and without complying with other requirements under FSMA 2000, such as conducting a cost benefit analysis) if it considers it necessary or expedient to do so to advance its consumer protection objective amongst other things.. Product intervention rules made in this way are temporary and may only last for a maximum of 12 months.

The FCA has used the powers conferred on it under FSMA 2000, ss 137D and 138M to make temporary product intervention rules to impose restrictions in relation to the distribution of cocos to retail investors. The Temporary Marketing Restriction (Contingent Convertible Securities) Instrument 2014, FCA 2014/47 will come into effect on 1 October 2014 and lapse on 1 October 2015.

The cocos within the scope of the temporary rules are debt instruments with loss-absorbency features written into their contractual terms which are eligible under the Capital Requirements Regulation (EU) 575/2013, as either additional tier 1 or tier 2 capital. They either convert to common equity or have their principal amount written down on a permanent or temporary basis on the occurrence of one or more specified trigger events (usually a regulatory capital breach or at the point of non-viability).

The FCA rationale for intervention is its belief that cocos are risky and complex instruments, which present investment risks that are exceptionally challenging to evaluate and model. The FCA explains that these instruments have been developed to ensure that, in times of financial stress for the issuer, investors bear the costs of recapitalisation rather than the taxpayer. Accordingly, cocos may not meet the needs of certain types of investors (in particular, ordinary retail customers). The FCA has acted now to target cocos that meet the requirements for additional tier 1 or tier 2 capital because it is concerned that—given the enhanced regulatory requirements to maintain a prudent capital position and the current low interest rate environment— more firms will issue such cocos and, as a result, there is increasingly significant risk they will be inappropriately promoted to retail investors.

Who will the rules affect?

The temporary rules apply to all authorised persons in the UK, including both issuers of cocos and firms promoting or intermediating transactions in cocos. They apply to the distribution of new issues and of investments on the secondary market, including promotions to UK investors of securities issued abroad.

The rules provide that an authorised person must not:

  • sell a coco to a retail client in the European Economic Area (EEA), or
  • do anything that would or might result in a retail client in the EEA buying a coco or holding a beneficial interest in a coco

If the authorised person has taken reasonable steps to ensure that one or more of the exemptions summarised below applies, the prohibition does not apply to:

a) a person who qualifies as a certified high net worth individual, subject to specified conditions

b) a person who qualifies as an exempt person

c) a person who qualifies as a certified sophisticated investor

d) a person who qualifies as a self-certified sophisticated investor, subject to specified conditions

e) a retail client who solicits advice, subject to specified conditions

f) the sale or intermediation of a transaction in cocos, where an authorised person’s activities amount to the Markets in Financial Instruments Directive 2004/39/EC (MiFID) or equivalent third country business

g) the distribution of a prospectus required under the Prospectus Directive 2003/71/EC

h) an issuer, in the context of secondary market trading of cocos

i) the clearing, registration or settlement of transactions in cocos (or rights to, or interests in, such instruments), any back office processing or reporting of such transactions, or custody of cocos

j) certain specified indirect investments

Where an authorised person’s activities amount to MiFID or equivalent third country business, the rules do apply restrictions in relation to promotional activities (although not to the sale or intermediation of a transaction in cocos, as noted above at (f)).

The temporary rules require authorised persons to make a record of their assessment of the retail investor under the available exemptions where they promote (or approve financial promotions of) investment in cocos.

How and when will permanent rules be implemented?

The FCA is in the final stages of preparing a consultation exercise in relation to a permanent marketing restriction on cocos. However, given its current concerns about cocos and the fact that it would take several months before permanent rules could be put in place, decided it was necessary to take action now in order to reduce or prevent consumer detriment. The FCA expects to publish its consultation paper about proposed permanent rules on cocos in September 2014. After considering the feedback, it aims to publish a policy statement in Q2 2015, with final rules scheduled to take effect on 1 October 2015, when the temporary product intervention rules expire.

What should lawyers advise their clients in light of the new requirements coming into effect?

Lawyers must consider whether their client and its proposed activity is within the scope of the temporary rules. If so, lawyers must consider whether one of the exemptions summarised above applies. Lawyers should also note there is a waiver process which could be available to a client subject to the rules. The FCA will consider granting a waiver if:

  • an authorised person is able to demonstrate that complying with the rules would be unduly burdensome or would not achieve their purpose

  • the waiver would not adversely affect any of the FCA’s operational objectives

How does this fit in with other developments in the law in this area?

The European Supervisory Authorities (ESAs) have also expressed concerns regarding the practices used by some financial institutions to comply with the enhanced prudential requirements resulting from recent EU legislation. In July 2014 the European Securities and Markets Authority published a statement aimed at warning institutional investors of the potential risks associated with investing in cocos.

The Joint Committee of the ESAs also published a reminder to financial institutions about the applicable regulatory requirements with regard to placement of financial instruments with depositors, retail investors and policy holders. Whereas the ESAs and some other domestic regulators do not yet have the same product intervention powers as the FCA, given the extent of the concern about cocos, it is possible that EU level guidance or recommendations could be issued.

Alexandria Carr is a qualified barrister practising as Of Counsel with the Financial Services, Regulatory & Enforcement group at Mayer Brown. Alexandria’s main focus is on EU financial services regulation, providing regulatory advice on transactional matters and advising on discrete regulatory projects. She has previously worked for the UK government for 13 years, the last five of which she spent at the UK’s Ministry of Finance, HM Treasury, working closely with people across government, the then FSA, the Bank of England, ministries of finance across Europe and the institutions of the EU.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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