The EU Prospectus Regime

The EU Prospectus Regime Paola Lucantoni 1

Introduction Purpose of session Examine (in outline) the traditional objectives of disclosure/prospectus regulation → Through the EU lens and the 2003 Prospectus Directive (+ reforms, primarily 2010) ‘Market-making’ and ‘market-shaping’ The regulatory promotion of market finance in the EU and prospectus regulation → Regulatory styles and prospectus regulation Regulation + Liberalization Institutional reforms? ESMA role? Capital Markets Union and prospectus reform…. Regulation end of spectrum or liberalization? How the harmonized prospectus system is designed 2

Introduction A disclosure-based sector of EU financial regulation Should EU harmonization/market access be easier to support through? (as compared to, e.g., investment firm/intermediary regulation) Why? Regulatory design and perimeter controls Scope: which markets; which issuers; which offers? ‘Law on books’ and ‘law in action’ How is prospectus supervision and enforcement organized? Who does what – EU/MS? Is liability addressed? Does ESMA (the European Securities and Markets Authority) play an important role? Should it? What is the role of pan-EU supervisory design here? Differing levels of institutional integration – Capital Markets Union/Financial Union? Leading to a single supervisor? 3

Reform forces: Capital Markets Union Reform Agenda to strengthen market finance in the EU Green Paper, February 2015; Action Plan, September 2015; Progress Report, September 2016 Short-term; long-term measures; new measures; revision of current measures Major political priority - but part of a very long trajectory (1966) Primarily single market/liberalization-driven in orientation Contrast Banking Union (euro area) Primarily regulatory – not institutional - in nature Contrast Banking Union (institutions) But ‘Financial Union’ and ‘Completing EMU’? Key issue: CMU includes major proposal to revise the prospectus regime Signals change in approach to prospectus regulation? 4

CMU/Market Finance and the Prospectus Regime The connection to the prospectus regime: CMU is concerned with financial intermediation structures Movement of funds from capital suppliers (households/funds/insurance companies) to capital seekers (firms) Classically, bank and market-based intermediation (finance) CMU supports market finance → What is market finance? Funding through the issuance of transferable securities by firms (companies) Supported by channels/actors which intermediate the sale of securities Different types of issuer Different types of investor: Consumer/retail/household Wholesale/institutional pension funds/insurance companies/investment funds, including specialist funds (venture capital) 5

CMU/Market Finance and the Prospectus Regime Market finance generally weak in the EU Classic ratio is 80 (bank lending)/20 (market funding) for EU companies Associated with different economies UK; Netherlands (to some extent) Strong in the US → EU prospectus regulation as ‘market-making’ in style Transformative regulation, driving market finance Reform under CMU, but prospectus regime long concerned with market finance Brexit effects? More market-shaping (regulatory in nature)

Overview: EU Regulation Our concern: issuers (produce a prospectus; sell securities; disclose information) Primarily: disclosure/information-based regulation Prospectus: marketing document with extensive disclosure on the issuer. But primarily a legal tool, to support prospectus approval by national competent authorities and related ex-ante due diligence by the issuer; and ex-post private and public liability mechanisms Critical for addressing fraud and risk to investors Agency risks and the ‘promoter’s problem’ (ahead) The Facebook example – which disclosures? 7

Overview: EU Regulation • Ongoing disclosure (annual reports etc.) • Critical for price formation on trading venues (prices react to information) + market efficiency

Overview: EU Regulation (a) * 2003 Prospectus Directive, revised 2010: mandatory approved prospectus requirement Prospectus requirement (scope); disclosure content; supervisory approval process; publication to the public; sanctions Detailed disclosure; not formally ‘maximum harmonization’ but de facto + heavy reliance on delegated rules (b) 2013 Transparency Directive: ongoing disclosures, including financial reporting Half yearly report; annual report; and content Filing requirements (no supervisory approval) + dissemination requirements More limited harmonization than under Prospectus Directive, but becoming more detailed Incorporation of financial reporting rules for half yearly and annual reports from International Financial Reporting Standards

Overview: EU Regulation (c) International Financial Reporting Standards (via 2002 IAS Regulation) (the language for financial information) IFRS – imported from the International Accounting Standards Board (d) 2013 Market Abuse Regulation: ongoing disclosure relating to ad hoc material events; and rules preventing market abuse – i.e., insider dealing by the issuer Focus on protecting the market from fraud and supporting strong price formation Requirement to inform the public as soon as possible of ‘inside information’ directly concerning the issuer: Price sensitive information

Overview: EU Regulation • Current status? • Foundational model for prospectus regulation in the EU largely stable since the 2003 /2010 Prospectus Directive • Broadly seen as a success and a stable element of EU financial law • Core features (passport; perimeter design) replicated across EU capital markets law generally • But : • Major changes to follow with 2015 Prospectus Regulation Proposal under Capital Markets Union agenda • Deregulation - support SMEs • Regulation – risk factors; summary

Why Impose Mandatory Issuer Disclosure/Regulation? • In outline: • The importance of allocative efficiency in securities (capital-raising) markets • Scare resources → most productive purpose • Securities as intangible assets of contingent value/credence goods • The information asymmetry problem • ‘Promoter’s problem’ and incentive alignment difficulties • Incentives to under-disclose + fraud risks • Primary market (fraud) problems • Secondary market (pricing inefficiency) problems • Leads to discounting by investors; and → increasing the cost of capital 12

Why Impose Mandatory Issuer Disclosure/Regulation? • Rationale (1): Price Formation and Market Efficiency • Mandatory disclosure supports efficient pricing by mitigating the ‘lemons’ problem (secondary markets) + promoter’s problem (primary markets) • Standardized prospectus (+ongoing) disclosure provides a device for issuers to signal their credibility among lemons + • Economises information costs for investors by supporting the different mechanisms (including gatekeepers) who drive pricing • Rationale (2): Corporate Governance • Remedying agency costs of dispersed ownership in particular • Supports shareholders in taking action 13

Why Impose Mandatory Issuer Disclosure/Regulation? • Rationale (3): Investor Confidence and Investor Protection • The difficulties with this rationale – a distorting effect? • Do EU retail investors rely on prospectus disclosure/invest directly in equities/debt? No • Popularity of complex, packaged investment products • Importance of specific product disclosure – ‘Key Investor Information’ summary document under ‘UCITS IV’ mutual fund regime • Roll-out across the investment products sector –horizontal ‘PRIIPs’ (‘packaged retail insurance and investment-based products’) disclosure regulation • → Inefficient use of EU regulatory resources to adopt a harmonized, retail-oriented disclosure regime for direct securities investment? 14

Why Impose Mandatory Issuer Disclosure/Regulation? • → But why mandatory disclosure? • Market incentives to disclose? • Why might disclosure not be produced? • ‘public good’ problems; incentives not to disclose • + Standardization and enforcement benefits • But: why is disclosure regulation risky? • Law-making risks (capture, inefficiency) • Costs (CMU agenda) 15

Distinct Features of Prospectus Directive • Defining features • (1) Market liberalization (passporting) + regulation (harmonized disclosure regime to support home MS control) working together • (2) Law on the books or law in action? • A ‘law on the books’ regime at EU level • ESMA does not approve prospectuses – this occurs at the home MS level (some support building for this to be conferred on ESMA (IMF, e.g.)) • But: limited engagement with supervisory practices and liability devices – some developments with ESMA (peer review on how prospectuses are approved at national level) • Supervision and liability at national level • Is this a problem? 16

Distinct Features of Prospectus Directive • (3)Maximum harmonization? • What is maximum harmonization? • Not de jure: in theory – MS can apply more stringent rules to their own issuers (not ‘passporting’ issuers) in spaces where the harmonized prospectus regime does not cover particular disclosures • But de facto: the EU rule-book in this area is very thick, composed of the level 1 directive, level 2 technical/delegated rules, and related ESMA soft law and → limited room for MS law • And - few incentives for MS to impose additional obligations on their issuers • + Regulation under development 17

Distinct Rationale • What is the rationale for the Prospectus Directive and the EU’s related efforts to build a deep and liquid market for capital raising? • Issuer disclosure is the most longstanding part of EU financial law (dates to the late 1970s) • Why was issuer disclosure the first segment to be addressed? • Rationale (1) The market finance model • Rationale (2) The benefits of an integrated capital market(s) • But….the limitations of law; has market finance/integration taken root? (ahead) • Pan-EU public offers remain rare 18

Distinct Rationale • What role does harmonization play in supporting a single capital market? • At base: supports the issuer passport and the removal of host State control over cross-border issuers and prospectuses • From the issuer’s perspective? • Supports issuer passport; related cost reduction • Increase in standards and → enhanced signalling for issuers, and a reduced cost of capital? • From the investor’s perspective? • Wholesale market • Wider investment opportunities; lower transaction costs • Retail market • Diversification? High standards? • From the perspective of the home and host MS? • → How detailed does harmonization need to be? 19

Distinct Rationale • But what are the risks of harmonization? • Removal of regulatory competition • Is this a good outcome? Why? • Is supervisory competition possible under the EU regime? • See ahead • Risks of intervention • Innovation and flexibility locally lost? Why might this be important? • Is a strong market linked to law/harmonization? • Why are equity and bond fund raising markets currently relatively strong? • Is law critical ? • → CMU?? A Prospectus Regulation?? 20

Evolution • Was the 2003 Prospectus Directive a cornerstone of the Financial Services Action Plan? • Why was it central to the FSAP? • Was there a political consensus on the need for reform? • → Why were the negotiations contested given the political consensus? • What were the flashpoints? • What do they suggest as to the difficulties posed by EU rule-making?

Scope • Scope and perimeter issues (1) – which markets? (A 1(1); 3(1) and 3(3)) • Retail and wholesale design interests/priorities • When does the Directive apply? • (1) admission to trading on a ‘regulated market’ (2) offers to the public (Article 1(1)) • Article 3(1) and 3(3) apply the prospectus publication requirement to offers to public/admissions to RM • To what does it apply? • Is a cross-border element required? 22

Scope • What is a ‘regulated market’? (A2(1)(j)) • Venues ‘opt in’ to this status; a regulated market (RM) is one which chooses to be regulated under the regime which applies to RMs under MiFID (MiFID II from 2018) • Why is the RM concept used to define the scope of the regime? • The impact on ‘exchange-regulated markets’ /multi-lateral trading facilities (MTFs) and on SMEs (no EU prospectus requirement – but no passport) • Does this matter? • SMEs and the ‘funding escalator’

Scope • What is a regulated market de jure? • A multilateral system operated and/or managed by a market operator, which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments - in the system and in accordance with its non-discretionary rules - in a way that results in a contract, in respect of financial instruments admitted to trading under its rules and/or systems, and which is authorized and functions regularly and in accordance with Title III of this Directive: Markets in Financial Instruments Directive II 2014

Scope • What is a regulated market de facto? • It is an opt-in classification. • Trading venues choose to be regulated as ‘regulated markets’ under MiFID title III • The largest, most liquid, and most heavily regulated trading venues in the EU; typically longest established, heavy trading activity, including by consumers, and prices which act as wider market benchmarks • Ex: London Stock Exchange Main Market (regulated market) • Ex: London Stock Exchange Alternative Investment Market (not a regulated market – an ‘exchange-regulated market’/MTF) • → The ‘regulated market’ classification is a regulatory proxy for the trading venues most in need of heavy regulation given their systems wider impact and need for investor protection

Scope • → what is an offer to the public?(A 2(1)(d)) • Communication to persons, any form/means, presenting sufficient information, to enable investor to make a decision • What are the difficulties with this approach? Is it harmonized? Who should clarify this definition? • Why is a broad definition adopted? 26

Scope • Scope and perimeter issues (2) – which securities? (A 2(1)(a)) • Broadly defined – ‘transferable securities’ • Special treatment for certain debt securities – why? • And sovereign debt (A1(2)(b))– should this be reconsidered? • Banking Union reforms and reconsideration of special treatment of sovereign debt

Scope • Scope and perimeter issues (3) – which offers are exempted? • Why does this matter? Does the Directive seek to protect the wholesale/professional markets? • Ex (1) Private placements - offers to sophisticated (‘qualified’) investors (A 3(2)(a)) exempted; A 2(1)(e) definition of a QI (revised by 2010 Directive) • What is the purpose of this exemption? • Is it well-defined? • Financial institutions • Large corporates (over: euro 20 million balance sheet, 40 million turn-over, 2 million own funds (2/3)) • Natural persons meeting competence (1 year experience in financial markets) dealing (at least 10 transactions of significant size per Q over last 4 Qs); and assets (euro 500,000 portfolio) tests (2/3) 28

Scope • Similarly, A3(2)(c) and (d) • Also directed to sophisticated investors • Linked to offers of large denomination debt (at least euro 100,000 consideration/denomination (2010 revisions)) • And wholesale debt markets receive additional special treatment • Retail market risks….? 29

Scope • The Article 3(2)(a)/(c)/(d) exemptions (as for all of Article 3(2)) lifts on a re-sale – a prospectus must be provided if the re-sale can be defined as a public offer • And (as for all of Article 3(2)) not available if the offer is also admitted to trading on a regulated market (Article 3(3)) 30

Scope • Ex (2) Small offers and offers by SMEs (A1(2) and 3(2)(e)) • Offers below euro 5 million can be exempted (since 2010 revisions) (optional for MS) (A(1)(2)(h)) • Offers below euro 100,000 must be exempted (mandatory for MS) (A3(2)(e)) • Is this an internally consistent exemption – risks to investor protection? Liquidity risk? • Crowdfunding • Capital Markets Union – standardize? 31

Scope • Scope and perimeter issues – which offers are exempted? • Ex (3) wholesale debt markets (A3(2)(c)/(d)) – eg securities with denomination of at least €100,000; consideration per investor of at least €100,000 (as previously) • Why is this exemption in place? • Structure of EU funding markets; longstanding practice; quality of market-led disclosures; MS generally support private placements cross-border in practice • Political economy of the PD • Changing with 2015 Prospectus Regulation Proposal 32

Scope • But: the problems harmonization/exemptions can cause • Difficulties with the debt market exemption (as before) • Complete contraction in the retail debt market, particularly in Germany, as issuers moved to offering only in large denominations – diversification problems? • Holistic regulatory design problem, given that PD meant to support retail investment? 33

Scope • Ex (4): specific issuer transactions (A 4) • Similar sets of exemptions for public offers (A4(1)) + admissions to regulated markets (A4(2)) • In effect, disclosure already available (eg, disclosure relating to a take-over) • Ex (5): specific situations • Ex: MS debt offerings; offerings of mutual fund units (A1(2)) 34

Approval and the passport • The Passport – how does it work? • The anchoring device → central to the Directive’s design • Highly contested because of the issuer choice debate • A3(1)/(3) and requirement for prospectus publication/approval; A 13 – prospectus must be approved by home MS • What is the home MS? • (1) Equity and small denomination debt (under € 1000) – MS of registration → no issuer choice (A2(1)(m)(i)) • → The removal of supervisory competition – does this matter? • What are the practical difficulties which might arise? Might a supervisor have incentives not to supervise the prospectus closely where the offer takes place entirely outside the home MS? Might this be practically difficult, given the language regime? Should supervisory competition be removed like this? • Is ESMA making a difference? 35

Approval and the passport • (2) The wholesale debt market – governed by issuer choice (where admitted to trading) (A 2(1)(m)(ii)) • Issuer choice where denomination per unit at least euro 1,000 • Heavily negotiated; demanded by industry • Where are the major specialist centres for debt? Luxembourg and London → specialization protected • This was also a factor in the contraction of the retail bond market (in practice denominations of €100,000 common) 36

Prospectus Disclosure • The Disclosure Regime: Structure of the approved prospectus • (1) The Prospectus Summary – retail market orientation of the Directive (A 5(2)) • Originally harmonized? No, but: 2,500 words; must be translated • An effective retail market device? • Cut and paste from prospectus; limited • Issuers blocked from providing additional disclosures as risk that such a longer document could be an ‘unapproved prospectus’ • Not tested • No independent civil liability • Any court action only based on full prospectus, and this could require translation • No empirical evidence 37

Prospectus Disclosure • The summary under Article 5 • Issuer must provide ‘key information’ • Common format for the Summary to facilitate comparability; • No civil liability re Summary, but liability where Summary does not provide key information, although tied to ‘when read together with other parts of the prospectus’ • Key information’ defined as: essential and appropriately structured information to be provided to investors with a view to enabling them to understand the nature and risks of the issuer, guarantor, securities, and to decide which offers of securities to consider further • 2012 delegated Commission Regulation 486/2012 provides the technical detail on the format and order of the Summary (e.g.: 15 page limit; no cross references; mandatory order of information; clear language requirement)

Prospectus Disclosure • But - do retail investors read disclosures? • And the liability risks? (only in relation to the prospectus, which may not be translated) • Is the PD a retail oriented measure? Should this be removed?

Prospectus Disclosure • (2) Shelf registration (A 5(3) + A 12) • Why is this important? Speed? • Registration document + securities note + summary • Securities note: information concerning securities • Registration document: information concerning issuer • Together – the approved prospectus • (3) The base prospectus (certain debt securities) and updating price supplements (A 5(4)) 40

Prospectus Disclosure • (4) Protecting the prospectus – supplements to required update the prospectus (A 16) • Between approval and final closing of offer • Managed by home authority • When? • ‘every significant new factor, material mistake, or inaccuracy relating to the information included in the prospectus which is capable of affecting the assessment of the securities and which arises or is noted’ in relevant time frame must be noted in a supplement to the prospectus • Supplement must be approved • Withdrawal rights arise

Prospectus Disclosure • The Disclosure Regime: Substance of the approved prospectus • A materiality obligation – why? • Role of the supervisor? Tick the box? Link to civil liability? • A5(1): all information necessary (according to nature of issuer/securities) to enable investors to make an informed assessment of assets and liabilities, financial position, profit and losses, and prospects of the issuer, and of rights; in clearly analyzable and intelligible form; A 7 provides for related technical/delegated level 2 rules • But does it – prospectus as a liability shield – not an information document? 42

Prospectus Disclosure • The Annexes to the Directive (based on IOSCO standards) • Somewhat dated now • + Highly detailed technical level 2 rules • Building blocks and schedules • Highly detailed • Any discretion for local supervisors? 43

Prospectus Disclosure • The Disclosure Regime: Substance • Building a single rulebook under A 7 • How? Role of ESMA • Are the rules calibrated/finessed? A 7 and proportionate disclosures • Through the technical level 2/delegated rules • Strong ESMA influence • Applies to SMEs/companies with reduced market capitalization 44

Prospectus Disclosure • Proportionate regime • SMEs: must meet 2 of the following 3 conditions: less than 250 employees; balance sheet of €43M or less; annual net turnover of €50M or less • Companies with ‘reduced market capitalization’: listed companies with capitalization of less than €100M) • Adoption of a ‘proportionate disclosure’ regime • Set out in Commission Regulation 486/2012 • New ‘proportionate disclosure’ regime. • The main benefit is that only 2 years of financial disclosure is required (3 is the standard)

Passporting • The Passport – how does it work? • Can regulators delegate prospectus approval? • Yes: A13(5): subject to agreement • Why might a home regulator delegate approval? • Do they do so in practice? No • Legal complexities; where does responsibility lie? • National authority’s liability governed by national law • Potential for ESMA to address this question • ESMA’s 2016 supervisory convergence agenda 46

Passporting • Prospectus Approval and Market Integration: the Passport • A 13 approval – what is meant by supervisory ‘approval’? (A2(1)(q)) • Positive act at the outcome of the scrutiny of the completeness of the prospectus (including consistency of information and its comprehensibility) • Once approved – mutual recognition and removal of host State competence (A 17) • Valid for host MS • Note: clear legal expression of mutual recognition (found in all EU measures) • Notification requirements (A 18) • Statement from home regulator that prospectus is in order • Why is the host regulator notified? (precautionary powers) 47

Passporting • The language regime (A 19) • Technical and practical – but necessary • Regarded as one of the great successes of the Directive • Essentially: (1) home MS offer only – language accepted by home CA; (2) offer outside home MS but not in home MS – language customary in the field of international finance, or language accepted by offering MS – at choice of issuer; (3) in home and other MS – language accepted by home MS and also language customary in the field of international finance, or language accepted by offering MS – at choice of issuer • Summary must be translated for host MS 48

Marketing • Is marketing covered? • Article 15: general principles • Advertisements relating to offer observe principles re where prospectus obtainable; be recognized as advertisements; not be inaccurate or misleading; consistent with prospectus • Home authority has competence over compliance • Should marketing regulation be harmonized? 49

Law in Action • Law in Action • Is private enforcement a technique for driving effective disclosure? • A 6 and the liability regime • MS rules on civil liability must apply to those persons responsible for the information (they are: issuer, or its administrative, management or supervisory bodies, offeror, guarantor); statement that to best of knowledge, information is accordance with facts and there are no omissions likely to affect its import • Is the failure to harmonize liability regimes a threat to issuers and the effectiveness of the passport? • Likelihood of litigation? • Variations across the MS 50

The EU Prospectus Regime