ESMA Publishes Final Guidelines on Risk Factors under the new Prospectus Regulation
On 1 October 2019, ESMA published its finalised Guidelines on Risk Factors under the new Prospectus Regulation. The finalised Guidelines are substantially identical to those proposed by ESMA in its Final Report on proposed guidelines on risk factors under the new Prospectus Regulation published in March 2019. By their terms, the Guidelines will apply from 4 December 2019 and are to assist competent authorities when reviewing the specificity, materiality and presentation of risk factors. Nevertheless, anecdotally it appears that competent authorities have already begun to apply the principles as set out in ESMA's Final Report since the new Prospectus Regulation came into effect on 21 July of this year.
Summary
The proposed guidelines describe how ESMA expects competent authorities to apply the new Prospectus Regulation requirements in relation to both the content and the presentation of risk factors in prospectuses.
Content:
Specificity:risk factors must describe a relevant risk and must not comprise boiler-plate or generic risk factors and should not simply recycle the risk factors of prior or other prospectuses;
Materiality: the potential negative impact of the relevant risk must be clear from either quantitative or qualitative disclosure, and mitigating language should not obscure the materiality of the risk; and
Corroboration: the materiality and specificity of the risk factor must be demonstrated by either specific corresponding information or the general "overall picture" disclosed elsewhere in the prospectus.
Presentation:
Categorisation: risk factors must be categorised under appropriate headings and the number of categories should be limited to ten for a standard, single issuer, single security prospectus, albeit ESMA would permit sub-categories and a degree of flexibility generally for larger, more complex prospectuses;
Conciseness: risk factors should be focused and competent authorities should challenge the 'size inflation' of prospectuses; and
Order in the Summary: as the most material risk factors should be described first in each category, the disclosure of risk factors in the Summary should be consistent with the presentation in each category.
Background
With effect from 21 July 2019, the new Prospectus Regulation repealed and replaced the Prospectus Directive. Most of the legislative detail of the new regime, in the form of delegated legislation and regulatory guidance, came into effect at the same time. However one part of the new regime, ESMA's Guidelines on Risk Factors under the Prospectus Regulation (ESMA31-62-1293), has only just been published (on 1 October 2019). The Guidelines follow the publication by ESMA in March 2019 of its Final Report on proposed guidelines on risk factors under the new Prospectus Regulation and an earlier consultation paper, and the finalised Guidelines are substantially identical to those set out in the Final Report.
A key objective of the new Prospectus Regulation is to address the perceived proliferation of generic, boiler-plate risk factors in prospectuses and to require a more focused and streamlined approach to risk factor disclosure. In particular, Article 16(1) of the new Prospectus Regulation provides:
- The risk factors featured in a prospectus shall be limited to risks which are specific to the issuer and/or to the securities and which are material for taking an informed investment decision, as corroborated by the content of the registration document and the securities note.
- When drawing up the prospectus, the issuer, the offeror or the person asking for admission to trading on a regulated market shall assess the materiality of the risk factors based on the probability of their occurrence and the expected magnitude of their negative impact.
- Each risk factor shall be adequately described, explaining how it affects the issuer or the securities being offered or to be admitted to trading. The assessment of the materiality of the risk factors provided for in the second subparagraph may also be disclosed by using a qualitative scale of low, medium or high.
- The risk factors shall be presented in a limited number of categories depending on their nature. In each category the most material risk factors shall be mentioned first according to the assessment provided for in the second subparagraph.
The new Prospectus Regulation introduces other requirements in relation to risk factors, including setting a limit of 15 on the overall number of risk factors which may be included in any Summary.
The new Prospectus Regulation expressly mandates ESMA to develop Guidelines to assist competent authorities in their review of the specificity and materiality of risk factors and of the presentation of risk factors across categories depending on their nature. The new Prospectus Regulation also expressly empowers the Commission to introduce legislation on this topic – presumably to cover the possibility of ESMA's Guidelines not in practice producing the desired result.
The Guidelines
There are 12 Guidelines: two devoted to specificity; three to materiality; one to corroboration; four to categorisation; one to concise drafting; and one to the Summary. The Guidelines are addressed to competent authorities for their consideration when scrutinising and approving a prospectus under the new Prospectus Regulation, rather than to market participants.
The proposed Guidelines in ESMA's earlier consultation paper exhorted competent authorities to ensure that the Guidelines were adhered to, with the underlying sanction that the prospectus should otherwise not be approved. The Guidelines in final form have toned this down and now instead simply exhort competent authorities to challenge those responsible for the prospectus where it is not clear that the Guidelines have been followed.
Specificity and materiality
Relevant risks to the issuer/guarantor or the securities only
Each risk factor should identify and describe a risk that is relevant for the issuer/guarantor or the securities. Competent authorities should challenge the inclusion of 'boiler-plate' or generic risk factors or risk factors which are not risks at all but merely disclaimers.
Risk factors should not merely be copied from other documents published by other issuers or previously by the same issuer. However, the Guidelines recognise that issuers operating within the same industry may be exposed to similar risks and therefore disclosure related to these types of issuers can indeed be similar. Nevertheless, industry/sector specific risks may affect issuers differently depending, for instance, on their size or market shares, and therefore, it is expected that, where relevant, these differences are also reflected in the disclosure of a given risk factor.
Not all risks should be disclosed, just those that are 'material'
Not all risks that are specific to the issuer/guarantor or the securities should be disclosed in a prospectus, only those which are material for an investment decision. In this context, ESMA's Final Report notes that Article 16(1) of the new Prospectus Regulation sets out a materiality test addressed to those responsible for drawing up a prospectus, namely that materiality of risk factors should be based on the probability of their occurrence and the expected magnitude of their negative impact.
The materiality of the risk must be described
The Guidelines encourage, where available, the disclosure of quantitative information in order to illustrate the potential negative impact of a risk. However, if quantitative information is not available, the description of the potential negative impact of the risk factors may be described using a qualitative approach. In such case, ESMA notes that one option for the presentation of the materiality of risk factors may be by reference to the scale of low, medium or high (as per Article 16(1) subparagraph 3 of the new Prospectus Regulation), although it acknowledges that such disclosure is not mandatory.
It is the issuer's responsibility - not the competent authority's - to assess materiality
Competent authorities are not required to assess the materiality of a risk factor, the materiality assessment of risks remain the responsibility of the issuer who should ensure that the disclosure of the risk factor clearly demonstrates that the risk is material. However, the competent authority should ensure that the materiality of the risk factor is apparent from the disclosure of the risk factor.
Examples of risk factors which satisfy specificity and materiality
The Guidelines provide a number of straightforward examples of what ESMA considers appropriate risk factors with explanations of how they adhere to the Guidelines. However ESMA was concerned that that these might be used literally so, as they are intended only for illustrative purposes, they have been moved to appear in an Appendix to the Guidelines. For example:
Exchange rate risk in a base prospectus where multiple currency bonds may be issued via final terms, where the currency of the home and host Member States is the euro:
- Bonds issued via final terms pursuant to this Debt Programme may be issued in a currency which is not the euro, such as the Eurodollar or Euroyen bonds. According to the terms and conditions of the base prospectus, all payments related to certain bonds, including interest, may therefore be in dollars, yen or any other currency specified in this base prospectus.
- The euro value of any payments may be subject to significant fluctuations in exchange rates. The degree to which such exchange rates may vary is uncertain and presents a highly significant risk to the value and return of any bond issued pursuant to this Programme.
- Significant movements in currency exchange rate may not correlate with movements in interest rates and the timing of changes in the exchange rates may negatively affect the yield, the return and market value of the bonds. This may result in a significant loss on any capital invested from the perspective of an investor whose domestic currency is the euro.
ESMA's consultation described this as a "clear illustration of specificity and specific risks related to bonds issued in a currency other than the domestic currency of the investor ... The risk factor illustrates how changes in exchange rates might dictate the euro value of an instrument held by any investor who wishes to purchase or subscribe for non-euro denominated bonds. The materiality is illustrated by the periodic variations and frequency of scope for rate mismatches between a currency pair along with further potential compounding factors. In addition, the materiality is illustrated by the fact that there is a level of uncertainty regarding the extent of any mismatches in value and the potential loss which may occur on any capital invested.". The Appendix to the Guidelines states simply that this example "illustrate[s] the specificity and materiality of risk factors to the security".
The Appendix also provides an example of a compliant risk factor in relation to subordinated notes and the EU Bank Recovery and Resolution Directive.
Mitigating language must not compromise the description of the materiality of the risk
Mitigating language must not be included in a risk factor where it reduces the investor's understanding of the materiality of the risk and leaves the potential negative impact unclear. However, mitigating language is permissible if it is used to illustrate the probability of a risk's occurrence and the expected magnitude of its negative impact. The Appendix gives the following as an example of mitigating language in a risk factor which should be removed:
- In the course of its business activities, the Group is exposed to a variety of risks, including credit risk, market risk, liquidity risk and operational risk. Although the Group invests substantial time and effort in risk management strategies and techniques, it might nevertheless fail to manage risk adequately in some circumstances.
Corroboration
The Guidelines provide that in most cases a competent authority should not approve a prospectus where it is not apparent that materiality and specificity are corroborated by a reading of the prospectus. However, this will not always be the case, for example where materiality and specificity of a risk factor is identifiable by reference to the "overall picture" of the issuer/guarantor and the securities presented in the prospectus.
Categorisation
The Guidelines leave no doubt that a competent authority should not approve a prospectus when risk factors are not presented in categories based on their nature. Each category should be identified by the use of appropriate headings and the number of categories should be proportionate. ESMA considers that including more than ten categories in the case of a standard, single-issuer, single-security prospectus, would likely be disproportionate and that fewer categories may be required in appropriate cases, though it recognises that there may be circumstances where a larger number of categories is appropriate - for example, in the case of a multi-product base prospectus.
Within each category the most material risk factor must be presented first, though ESMA specifically notes that it is not mandatory for all the remaining risk factors to be ranked in order of their materiality.
The Guidelines provide specific examples as to how categories of risk factors could be presented for both the issuer/guarantor and the securities.
With regard to sub-categories, the Guidelines provide that sub-categories should only be used where their inclusion can be justified on the basis of the particular prospectus. ESMA notes that, for example, sub-categories may be appropriate in a base prospectus containing multiple types of securities.
Conciseness
Risk factors should be presented in a concise form. Competent authorities should address the issue of the 'size inflation' of prospectuses, where this is due to the inclusion of large quantities of information surrounding risk factors. The consultation pointed out that ESMA considers that an example of the 'over-inclusion' of information surrounding risk factors is background information concerning the origin of the Bank Recovery and Resolution Directive (BRRD): Although this example is not repeated in the Final Report or the Guidelines themselves this probably should not be taken as an indication that ESMA has changed its view in this case.
Prospectus liability
While the desire of legislators and regulators to see relatively few, pithy risk factors in a prospectus is understandable, the fundamental problem this approach encounters is the fact that the persons responsible for the contents of a prospectus, such as the issuer or guarantor or their directors, have potential legal liability to investors for the accuracy and completeness of the prospectus. By contrast, the competent authorities which are encouraged by the Guidelines to challenge the drafting of risk factors do not accept responsibility to investors for the contents of the prospectus and often have statutory immunity.
Particularly in the context of an international offering of securities it can be difficult if not impossible to determine in advance in which country's courts an investor may bring an action or which country's laws will be invoked to determine liability. In these circumstances it is understandable that those persons having legal liability for the accuracy and completeness of the prospectus wish to leave nothing to chance when deciding what information to include in a prospectus. While a competent authority can challenge the inclusion of information in a prospectus, it has very little power to prohibit its inclusion. Thus, if the person responsible for a prospectus has a genuine belief that certain information is material, any challenge from a competent authority will generally boil down to a question of how the information is presented in the prospectus rather than whether it is included at all.
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Authors: Mike Logie and Tim Morris
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