PRIIPs developments in the UK: an update

The FCA and the EU have both recently proposed changes to regulatory technical standards (RTS) which cover similar topics (performance scenarios and costs) under their own PRIIPs regime.

This note looks at the proposals set out by the FCA. For details of developments in the EU, see our separate note, here.

The FCA’s Proposed PRIIPs RTS

On 20 July 2021, the FCA published CP 21/23, “PRIIPs - Proposed scope rules and amendments to RTS” (the CP), in which it set out its proposed amendments to the UK’s on-shored PRIIPs regime.

As well as changes to the RTS themselves, the proposals would create a new Sourcebook as part of the FCA rules, the Product Disclosure Sourcebook or DISC.

The CP also links to the FCA’s proposed new Consumer Duty – para 1.32 of the CP notes “our work on the new Consumer Duty highlights the importance of communication through disclosure and aims to be give consumers the information they need, at the right time, and present it in a way they can understand.”

The consultation period closes on 30 September 2021 and the intention is for the consequent rule changes to come into effect on 1 January 2022 (although it is fair to say that the timing is very tight).

The CP includes proposals on the following areas:

• Scope for corporate bonds and legacy trades.
• Guidance on the term ‘Made available’.
• Performance scenarios.
• Summary Risk Indicators (SRIs).
• Transaction costs.

A. Scope for corporate bonds and legacy trades

What is the FCA concerned about?

Certain common features of corporate bonds make it unclear whether or not they are PRIIPs (eg make wholes and change of control puts). Therefore, liquidity and choice has been restricted in the corporate bond market as firms take a conservative view.

There is also uncertainty around legacy products (i.e., those which were issued before PRIIPs came into force but are still available for trading on secondary markets). Again, this has led to firms taking a conservative approach, creating liquidity issues in secondary markets.

What is the CP proposing?

The CP sets out (at paras 2.5 and 2.6) some uncontroversial examples of PRIIPs and references the Statement published by the European Supervisory Authorities (ESAs) on 24 October 2019, which, while useful, is not legally binding. The rules which the CP proposes are broadly in line with that Statement.

The effect of the CP’s proposals would be to distinguish between:

a) corporate bonds which contain features that introduce a degree of variability or uncertainty to the overall return to investors, but which are properly viewed as non-packaged, direct investment in the business of the issuer; and
b) corporate bonds where the overall return to investors is substantially determined by the performance of investment assets the investor does not purchase, or which are better regarded as a packaged investment due to their complex features.

The CP’s proposals would clarify that:

• To be a PRIP - a debt security must come between the retail investor and an ultimate investment asset which is not purchased by the investor. Returns to the investor are materially determined by price movements or the investment performance of assets other than the debt security itself, including reference assets and indices or benchmarks relating to assets or a class of assets.
• To not be a PRIP - the overall return of the debt security for the investor must be determined by the economic performance of the commercial or industrial activities of the issuer.

B. Guidance on “made available”

What is the FCA concerned about?

As things stand, it’s not clear what steps a PRIIPs manufacturer or distributor must take to demonstrate that a PRIIP is not being ‘made available’ to retail investors. This has led to some manufacturers taking a conservative approach to secondary markets and restricting their products so they can’t be sold to retail clients.

What is the CP proposing?

The CP contains guidance that a financial product is not “made available” where:

• marketing materials for the financial instrument (including the prospectus) make it clear that it is being offered only to professional clients or ECPs and that it is not intended for retail investors;
• the marketing and distribution strategy for the PRIIP is, in fact, targeted at professionals and ECPs and not retail clients; and
• the financial instrument is issued at a minimum denomination value of £100,000 (or the equivalent sum in a non-sterling currency).

C. Performance scenarios

What is the FCA concerned about?

Currently, the calculation of performance scenarios can produce misleading results.

The FCA is proposing to replace performance scenarios with narrative information. Section 38 of the Financial Services Act 2021 removes the reference to ‘performance scenarios’ and, instead, provides a more flexible requirement that the KID should contain ‘information on performance’.

What is the CP proposing?

The FCA intends to remove performance scenarios altogether. Annexes IV and V of the RTS would be deleted in their entirety.

Instead, the FCA is proposing a new Annex IVA, which sets out the requirements for performance information to be included in the KID.

The narrative explanation would need to include the factors likely to affect future performance, including:

• those factors most likely to determine the outcome of the investment and those which could have a material impact on its performance;
• the most relevant index, benchmark, target, or proxy, along with an explanation of how the PRIIP is likely to compare in terms of performance and volatility;
• an explanation of a favourable, negative, or worst scenario for how the investment performs;
• 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.

Rules or guidance could identify the factors that manufacturers should include – for instance, the degree of volatility or sensitivity to changes in interest rates, etc.

Past performance: the FCA has noted that it is not proposing to include past performance in KIDs since some products do not have sufficient data to make this of value. It has, though, included draft rules in the new Annex IVA which would include past performance to illustrate what a requirement to display past performance would entail.

D. SRIs

What is the FCA concerned about?

There have been concerns raised that the SRI produced following the RTS methodology appeared to deliver lower risk ratings than expected when the PRIIP’s underlying, or reference asset is illiquid. Concerns were also raised about the SRI not capturing all risks associated with some PRIIPs. It appears the SRIs produced under the current methodology have the potential of under-estimating the overall level of risk that retail investors should take into consideration.

What is the CP proposing?

The CP includes a proposal to introduce a requirement in the RTS whereby PRIIPs manufacturers would need to upgrade the SRI of their product if they consider that the risk rating produced by the methodology is too low. They would be obliged to ensure the SRI is “appropriate and unlikely to mislead investors”.

In addition, PRIIPs manufacturers would have to notify the FCA by email if they have upgraded their products’ SRI score, the notification of which would need to include:

• identifying information for the relevant PRIIP (name of the product, tranche, issuer, etc);
• the new score the manufacturer has assigned to the product as well as that which would have been assigned under the RTS methodology; and
• a brief explanation of the risk factors the manufacturer believes were not adequately reflected in the summary risk indicator.

The FCA also proposes that PRIIPs issued by VCTs must be assigned an SRI score no lower than six.

An amendment to the RTS is also proposed which would increase the current 200 character limit for Element E to 400 characters to allow room to explain all other significant risks.

E. Transaction costs

What is the FCA concerned about?

Concerns have been raised that the slippage methodology can lead to negative transaction costs and around the general accuracy of transaction cost reporting.

What is the CP proposing?

The FCA is proposing to maintain the slippage methodology; it is deemed to be working as intended and is considered to be the best way to calculate transaction costs, with negative costs being quite rare.

The FCA is proposing amendments in the following areas:

Anti-dilution: Where the amount of anti-dilution benefit is more than all the transaction costs incurred, this should not be considered in the reporting of transaction costs.

Calculation of transaction costs for debt securities: The FCA has advised that the best evidence that will be available for the market mid-price of a bond will be the average of the best bid and best offer obtained when seeking quotes from multiple counterparties.

Calculation of costs for index-tracking funds: Firms should use a spread model rather than slippage; the arrival price should be calculated as the mid-price immediately prior to the auction.

Average price: The FCA has advised that the correct approach is to calculate all transaction costs over three years and take the average for the whole period rather than a rolling average of annual transaction costs.

The FCA is also proposing to extend the data calculation exemption for the entrance of UCITS into the PRIIPs regime.

The FCA is proposing to allow firms to use the most recent available price, then a ‘justifiable’ independent price when calculating costs when the open/close prices lead to misleading results.

The FCA also proposes to add clarity to the methodology to be used for PRIIPs less than three years old to assist in issues with data for new PRIIPs.

Interaction with the EU’s revised RTS

As well as the FCA’s proposed amendments, the ESAs have recently proposed changes to the RTS developed under the EU PRIIPs regime. Please see our note on these revised RTS here.

There is significant divergence between the UK and the EU in a number of areas including:

There are many additional points of divergence where there is no overlap between the two proposals (for example, the amendments to costs calculation methodologies or the fact that the EU are changing the requirements for when intermediate holding periods must be shown, while the FCA does not touch on that).

In conclusion, whilst both sets of regulators are working towards the same aim of improving established problems with the PRIIPs Regulation, there is significant divergence in their proposed approaches which looks to result in a situation where a “UK KID” will need to be provided to UK retail investors, and an “EU KID” to EU retail investors. It will be important for firms and trade associations to engage at this point in the hope of minimising divergence.

We anticipate that this divergence will prove costly to PRIIP manufacturers who will need to draw up two different KIDs for the same product distributed across the UK and Europe. Arguably, perhaps significantly more than the average of £20.8k per firm estimated by the FCA in the CP.