FCA consults on changes to the UK PRIIPs regime

Key points

The FCA is consulting on a number of proposed changes to the UK PRIIPs regime:

• Replacement of performance scenarios with narrative information on performance;
• Mandatory inclusion of a graphical representation of the PRIIPs' past performance, subject to certain exemptions (the FCA is not actually proposing this change, just canvassing views);
• Obligation on PRIIP manufacturers to increase a product’s SRI risk rating score where the methodology under the PRIIPs regime produces a score that is misleadingly low;
• Expansion of the permissible risk disclosure narrative limit from 200 to 400 characters;
• Safe harbour conditions which may be followed to ensure that a PRIIP is not inadvertently 'made available' to retail investors in the UK, and therefore avoid the production of a precautionary KID;
• Clarity around certain terms and features of debt securities that will NOT make such securities a PRIIP; and
• Certain targeted amendments to improve the accuracy of transaction cost reporting.

Background

Upon the UK's withdrawal from the EU, the UK retained the EU's regulatory regime for Packaged Retail and Insurance based Investment Products (PRIIPs) derived from the EU PRIIPs Regulation¹  and the related EU Regulatory Technical Standards (RTS)²  but in a slightly modified form, by virtue of the European Union (Withdrawal) Act 2018 (EUWA))³ . We refer to the 'on-shored' UK PRIIPs regime as the "UK PRIIPs Regulation" and "UK PRIIPs RTS".

In July 2018, the FCA published a Call for Input seeking views and evidence on market participants’ initial experiences of the requirements introduced by the EU PRIIPs Regulation, and published its findings in a Feedback Statement (FS19/1). On 20 July 2021, the FCA published a consultation paper (CP21/23) on proposed amendments to the UK's PRIIPs regime to address:

• perceived lack of clarity on the scope of the PRIIPs regime;
• the circumstances in which a PRIIP is not made available to retail investors; and
• mandated performance scenarios and summary risk indicators which are seen as being potentially misleading.

Enabling legislative changes

With effect from 1 July 2021, the Financial Services Act 2021 introduced a number of changes across a wide range of UK financial services legislation including a new power (a new Article 4A inserted in the UK PRIIPs Regulation )⁴ for the FCA to make rules specifying whether a product, or category of products, falls within the definition of a PRIIP under the UK PRIIPs Regulation. The Act also amended Article 8 of the UK PRIIPs Regulation to give the FCA flexibility to explore how a KID can present performance scenarios in a way that is not misleading. The changes proposed by the FCA in CP21/23 would be made through a combination of amendments to the UK PRIIPs RTS and new rules and interpretive guidance in relation to the UK PRIIPs Regulation which will be contained in a new Product Disclosure sourcebook (DISC) to be added to the Listing, Prospectus and Disclosure block within the FCA Handbook.

Performance scenarios – replacement with narrative information on performance

The FCA has taken note of the feedback from its Call for Input that the production and presentation of performance scenarios and summary risk indicators can, for some products, result in misleading information in the KID. With regard to performance scenarios in particular, the FCA has concluded that, due to market conditions in the five years before 2018 as reflected in the current methodology requirements, "a high proportion of KIDs produced since the PRIIPs regime has come into force may be displaying illustrations of future returns that are significantly over-optimistic." The FCA has further concluded that it is unclear how the methodology could be improved to produce an appropriate result.

For these reasons, the FCA proposes to abandon performance scenarios entirely and replace them with a new narrative section "Investment performance information" expanding on the factors likely to affect future performance of the PRIIP. The narrative information should include an explanation of a favourable and negative, or worst case scenario and must, as a minimum, include the following elements:

• a description of the main factors likely to affect future returns for the investor, identifying those most likely to determine the outcome of the investment and other factors which could have a material impact on performance;
• identification of the most relevant index, benchmark, target, or proxy, as applicable, along with an explanation of how the PRIIP is likely to compare in terms of performance and volatility;
• a brief explanation of the kinds of conditions that would be conducive to the PRIIP generating higher returns;
• a brief explanation of the kinds of conditions whereby the PRIIP is likely to generate lower returns or lead to investment loss; and
• a brief description of what outcome the investor may expect where the PRIIP matures or is redeemed or encashed under severely adverse market conditions

The PRIIP manufacturer must ensure the narrative performance information is "likely to be useful to retail investors in assessing the prospects for future returns of investment in the PRIIP as well as comparing it with other PRIIPs", as well as "accurate, fair, clear, non-misleading and likely to be understood by the retail investors to whom the PRIIP may be offered" and "compatible with the information stating the objectives of the PRIIP disclosed in accordance with article 2(2)".

Key challenges of the proposed narrative approach include how to ensure (i) consistency of disclosure across KIDs and (ii) clarity to PRIIP manufacturers as to what constitutes compliant disclosure. To that end, the FCA consultation includes a question as to whether the FCA should specify the potentially relevant factors that the narrative should cover (e.g. "degree of volatility, sensitivity to changes in interest rates or other relevant benchmarks, etc.").

The FCA is further consulting on (though not proposing) the mandatory inclusion of a graphical representation of the PRIIP's past performance, with an exemption for PRIIPs that have been available for less than one year or where the PRIIP manufacturer feels such representation would be misleading.

SRI – obligation to increase the SRI risk rating score where it is misleadingly low

The FCA recognises that the methodology for determining a product’s summary risk indicator (SRI) relies heavily on volatility measures and this can lead to misleadingly low scores for some types of PRIIPs, particularly where the PRIIP’s underlying, or reference asset, is illiquid. Consequently, the FCA is proposing to introduce a positive requirement in the UK PRIIPs RTS for PRIIP manufacturers to increase a product’s SRI risk rating score if the manufacturer considers that the score produced by the methodology is too low. In such event, the PRIIP manufacturer must notify the FCA of the changed score and provide a brief explanation of the risk factors the PRIIP manufacturer believes were not adequately reflected in the summary risk indicator produced under the existing methodology.

Whilst the ability to increase misleadingly low risk rating scores will be welcomed, PRIIP manufacturers may feel some trepidation at the prospect of being vulnerable to potential challenge on SRI risk rating scores that have not been increased. It will also not be an entirely comfortable prospect that the SRI risk rating scores for the same product will be different as between UK and EU KIDs.

Narrative risk disclosure – doubling of permissible number of characters

The UK PRIIPs RTS allows PRIIPs manufacturers 200 characters to explain all other significant risks not covered in the SRI score calculations. In order to allow a better or more complete summary of key risks, the FSA proposes to double this limit to 400 characters.

PRIIP manufacturers will need to give such additional disclosure careful thought as the FCA has made clear that it expects such extended risk descriptions to be "clear and appropriate for retail clients, and … not simply link to, or replicate language used in a prospectus if this would not be easily understood by less sophisticated clients." As above with the SRI risk rating scores, PRIIP manufacturers may feel a degree of nervousness at having different risk disclosures for the same product as between UK and EU KIDs.

Scope – clarity around the exclusion of bonds with certain terms and features

The consultation proposes new FCA rules and guidance specifying whether debt securities – having certain terms and features - fall within the definition of a PRIIP for the purposes of the UK PRIIPs Regulation. These will be contained in a new Product Disclosure sourcebook (DISC) which will be added to the Listing, Prospectus and Disclosure block within the FCA Handbook.

The proposed rules provide that a debt security is a PRIIP where the amount of interest or principal payable, or the issuer’s default risk, is materially dependent on the following (whether or not modified by a pre-determined formula):

• fluctuations in reference indices or benchmarks relating to investment assets or a class of investment assets, for example a stock market index;
• the value or performance of reference investment assets, such as a basket of shares or specified commodities; or
•  the value or performance of investments held by the issuer (or a group company).

The proposals further provide that a debt security is NOT a PRIIP if it does not fall within the above description and:

• the issuer’s default risk is wholly or predominantly determined by the economic performance of the commercial or industrial activities of the issuer (or guarantor, if a group company); and
• with the exception of any of the features described in the next paragraph, the terms of the debt security do not impose any modification, structuring, or conditionality on the issuer’s obligation to pay interest or repay principal.

The proposed rules stipulate that the following features do NOT cause a debt security to meet the criteria for a PRIIP:

• a fixed coupon subject to pre-defined changes at fixed times prior to maturity (a stepped coupon);
• a floating or variable coupon, provided:
  
  • the interest payable is determined by an index or benchmark tracking the rate of inflation, money market interest rates, or other indicators pertaining to the performance of the general economy, with or without a spread reflecting the credit risk of the issuer; and
  • the interest payable is not subject to any additional modification or structuring such as a cap or a floor (other than zero);
• a put option on pre-agreed terms, or an option to convert or exchange into the issuer's shares at a pre-determined price;
• a call option, where:
  
  • the option becomes exercisable due to changes in the financial health, market confidence in, or control of the issuer, or general economic conditions; and
  • the mechanism to calculate the net present value of the future coupon payments is made clear to the investor in the terms of the debt security;
• a perpetual term; or
• the debt security’s subordination in the creditor hierarchy in the event of the issuer’s insolvency.

When is a PRIIP 'made available' – new safe harbour conditions

The obligation under the UK PRIIPs regime to produce and publish a KID only applies where a PRIIP is 'made available' to retail investors in the UK. The FCA refers to feedback from its Call for Input that respondents feel obliged to produce KIDs for certain PRIIPs even where the PRIIP is not intended to be offered to retail investors, given the possibility of such offer and sale in the secondary market. The FCA is therefore proposing guidance which effectively sets out certain "safe harbour" conditions which, if satisfied, will mean that the FCA will regard the PRIIP as not being 'made available' to retail investors in the UK, and therefore there should be no need on the part of the PRIIP manufacturer and initial offeror to prepare, publish or provide a UK KID.

The proposed conditions are as follows:

• a minimum denomination (or minimum investment) of £100,000 or equivalent applies to the PRIIP;
• the marketing materials (including the prospectus, if there is one) feature prominent disclosure to the effect that the PRIIP is being offered only to non-retail investors and is not intended for retail investors; and
• the issuer or the distributor has taken reasonable steps to ensure the offer and any associated promotional communications are directed only at people who are not retail investors.

This will be a welcome development for some PRIIP manufacturers, albeit further detail will need to be fleshed out, including whether disclosure in final terms suffices for the prospectus and what constitutes "reasonable steps" to ensure that marketing is directed only at non-retail investors.

Costs disclosure – targeted amendments as to transaction cost reporting

The FCA proposes to make a number of targeted amendments to improve the accuracy of transaction cost reporting in the following areas:

• treatment of anti-dilution;
• calculation of costs of over-the-counter (OTC) transactions in bonds; and
• calculation of costs of index tracking funds.

UCITS – confirmation that the changes will not immediately apply

The FCA confirms that its proposed amendments to the disclosure requirements will not immediately apply to UK UCITS schemes and certain non-UCITS retail schemes due to the existing exemption for these schemes, which it intends to extend shortly.

Next steps

The consultation is open until 30 September 2021. The FCA plans to make the final rules and amend the PRIIPs RTS by the end of 2021, with any changes coming into effect on 1 January 2022.
The FCA notes that this is only its first step towards improving disclosure in the consumer investment space. It intends to work closely with HM Treasury on its planned wholesale review of the disclosure regime for UK retail investors.

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^{1 Regulation (EU) 1286/2014
2 Commission Delegated Regulation (EU) 2017/653
3 The FCA has also stated that it will continue to apply the Guidelines and Recommendations of each of the three ESAs – the European Securities & Markets Authority (ESMA), the European Insurance & Occupational Pensions Authority (EIOPA) and the European Banking Authority (EBA) - in in the same manner after IP completion day (31 December 2020) as before that day, but interpreting them in light of the UK’s withdrawal from the EU.
4 Regulation (EU) 1286/2014 as it forms part of domestic law by virtue of the EUWA}