FCA finalises changes to UK PRIIPs regime

In July 2021, the FCA consulted (in CP21/23) on proposals to address the most serious and persistent concerns regarding the onshored PRIIPs regulation.

Following feedback from consultation CP21/23, the FCA are:

Introducing rules to clarify the scope of the PRIIPs Regulation for corporate bonds, making it clearer that certain common features of these instruments do not make them into a PRIIP
Introducing interpretative guidance to clarify what it means for a PRIIP to be ‘made available’ to retail investors
Amending the PRIIPs Regulatory Technical Standards to:
o Replace the requirements and methodologies for presentation of performance scenarios in the KID with a requirement for narrative information on performance to be provided
o Address the potential for some PRIIPs to be assigned an inappropriately low summary risk indicator in the KID
o Address concerns about certain applications of the ‘slippage’ methodology when calculating transaction costs

Below we highlight some of the key changes to the UK PRIIPs regime.

Rules clarifying the scope of the PRIIPs regime in the UK

The PRIIPs Regulation sets out a broad definition of what kind of investment is a PRIIP at article 4. In summary, article 4 of the PRIIPs regulation defines a PRIIP as one or both of a packaged retail investment product (PRIP) or an insurance-based investment product (IBIP), as follows:

A PRIP is an investment where, regardless of its legal form, the amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or to the performance of one or more assets that are not directly purchased by the retail investor (art. 4(1))
An IBIP is an insurance product which offers a maturity or surrender value which is wholly or partially exposed, directly or indirectly, to market fluctuations (art. 4(2))

The FCA were concerned about the apparent impact of the PRIIPs legislation on choice and liquidity in retail corporate bond markets, which may be limiting the ability of retail investors to sell, reinvest, or make new investments in this sector, while reducing the diversity of corporate bond funding sources.

To address this issue, the FCA proposed rules clarifying that certain features do, or do not, make a product into a PRIIP.

The rules look to distinguish between:

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 nonpackaged, direct investment in the business of the issuer, and
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 rules also 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. A debt security issued is not to be regarded as a PRIP (and therefore is not a PRIIP) if the overall return for the investor is determined by the economic performance of the commercial or industrial activities of the issuer. In contrast, a debt security would be a PRIIP where the 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.
Debt securities with fixed coupons are not PRIPs, even if the coupons are subject to pre-defined changes. The returns to investors in relation to these investments are not subject to fluctuations.
Incorporation of a put option that gives the investor a discretion to demand early repayment of the debt security or to convert it into one or more shares of the same issuer, in each case under pre-agreed terms, does not make the debt security into a PRIP. Similarly, a debt security featuring a call option allowing the issuer to redeem the debt security early at a price that is at least equal to par would not be a PRIP for that reason alone, provided the option is not exercisable in response to fluctuations in reference values or the performance or one or more investment assets.
A debt security will not be a PRIP simply by virtue of having a perpetual or indefinite term, or because of its subordination in the creditor hierarchy in the event of the issuer’s insolvency.
A debt security or indeed any other financial instrument issued or sold before 1 January 2018 is not a PRIIP.

To provide further clarity, in the policy statement the FCA provide guidance on certain products:

Product	FCA Response
FX forwards	FX Forwards, and FX Swaps, are derivatives. As outlined in FS 19/01, and explained on our website, we consider that derivatives, if offered to retail investors, would fall within the definition of PRIIPs
REITs	As outlined in FS 19/01, it is the responsibility of the manufacturer of REITs to determine whether the REIT is a PRIIP or not, on a case-by case basis
Listed Investment Companies	As outlined in FS 19/01,we maintain our view that if a collective investment undertaking falls within the definition of an ‘alternative investment fund,’ and is made available to the retail market, then it should be considered a PRIIP. A listed investment company would fall under that definition, notwithstanding that it is also a body corporate
Exchange Traded Derivatives (ETDs)	We maintain our view that ETDs are derivatives. As explained on our website, we consider that derivatives, if offered to retail investors, would fall within the definition of PRIIPs
SPACs	Generally, we would not consider a SPAC to fall in scope of the PRIIPs Regulation where it is publicly listed and follows the traditional model where the investor can either swap their shares in the SPAC for shares of the merged company or redeem once the acquisition is completed. However, it is the responsibility of the manufacturer to consider the features of a SPAC, particularly an unlisted entity, and determine whether it could constitute a PRIIP
Royalty Companies	We would typically consider a royalty company to be out of scope of the PRIIPs Regime where the assets held by retail investors are publicly listed corporate shares. However, it is the responsibility of the manufacturer to determine whether the Royalty Company offering is a PRIIP or not, on a case-by-case basis
US ETFs	As outlined in CP 16/18, a third-country manufacturer or distributor of a PRIIP to retail clients in the UK will be required to prepare and produce a KID
Sukuk	As the characteristics of a Sukuk can vary, it is the responsibility of the manufacturer to determine whether the Sukuk is a PRIIP or not, on a case-by-case basis
Regulated Covered Bonds	It is the responsibility of the manufacturer of regulated covered bonds to determine whether the characteristics of the bond mean that it constitutes a PRIIP or not, on a case-by-case basis
Sovereign Bonds	We do not consider sovereign bonds to fall within the scope of PRIIPs

Made Available

As per the proposals in the CP, the new rules contain guidance that a security which is not a PRIIP 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).

Information on Performance and Risk

Removal of performance scenarios

In the Consultation, the FCA proposed several changes to:

Remove performance scenarios from the KID and introduce a requirement for manufacturers to instead include a narrative description of performance in the KID
Require PRIIPs manufacturers to upgrade their product’s SRI if they consider that the risk rating produced by the methodology is too low, we also proposed requiring PRIIPs issued by VCTs to assign an SRI score no lower than 6
Increase the character limit for uncaptured risks from 200 characters to 400 characters

Narrative description of performance

The FCA have confirmed that they will proceed with their proposal to remove the requirement for PRIIPs manufacturers to display performance scenarios in the KID. This is because they resulted in manufacturers being subject to obligations that are incompatible with their duty to ensure the information in the KID is accurate, clear, fair, and not misleading.

To mitigate the risk of incomparable products, the FCA have introduced a narrative description of disclosure and issued further information on this.

Annex IV on performance scenarios provided in the PRIIPs RTS has been deleted in its entirety and replaced with a new Annex 4A on performance information.

The PRIIP manufacturer must ensure the performance information is:

Accurate, fair, clear, non-misleading and likely to be understood by the retail investors to whom the PRIIP may be offered;
Compatible with the information stating the objectives of the PRIIP disclosed in accordance with article 2(2);
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; and
Supported by objective data.

The information 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;
Under a sub-heading ‘what could affect my return positively?’, a brief explanation of the kinds of conditions that would be conducive to the PRIIP generating higher returns;
Under a sub-heading ‘what could affect my return negatively?’, 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.

Upgrade a product’s SRI score

The aim of the SRI is to help consumers choose a PRIIP in line with their risk appetite, therefore, under-estimation of overall risk undermines a key objective of the Regulation and may lead to harm if consumers buy products that pose a greater risk of financial loss than they wish to accept.

The FCA have introduced rules to require PRIIPs manufacturers to upgrade a product’s SRI score when the score resulting from the application of the RTS methodology underestimates the level of risk.

Notification Requirement

After evaluating feedback on the notification requirement, the FCA have decided not to proceed with this proposal. Manufacturers will not be expected to notify the FCA if they upgrade a product’s SRI score.

VCT assigned SRI of 6 or 7

In CP21/23 the FCA proposed that a VCT must be assigned a minimum risk score of 6. In the policy statement, the FCA maintain that 6 is an appropriate minimum SRI for VCTs and expect firms to upgrade the SRI score for their product if they consider 6 is too low.

Increased disclosure character limit for risk

The FCA have increased the character limit for the description accompanying the SRI. It is believed that this will facilitate a more complete summary of key risks, where appropriate. PRIIPs manufacturers must ensure descriptions of risk are clear and appropriate for retail clients, and do not simply link to, or replicate language in a prospectus if this would not be easily understood by less sophisticated clients.

What happens next?

The FCA changes to the PRIIPS RTS and new rules entered into force immediately on 25 March 2022.

However, firms will have until 31 December 2022 to implement the new changes.

The FCA have also made consequential date changes to the PRIIPs RTS and Handbook rules to align with the extension of the Undertakings for Collective Investment in Transferable Securities (UCITS) exemption contained in the PRIIPs Regulation (as enacted in retained EU law) to 31 December 2026.

Technical amendments to transaction costs disclosure requirements

The FCA have proposed several changes to improve the accuracy of transaction cost reporting in the following areas:

Treatment of anti-dilution
Calculation of over-the-counter (OTC) transactions in bonds
Calculation of costs of index-tracking funds

Anti-dilution

There will be no need to breakdown transaction costs, including disclosing where an anti-dilution mechanism is used. The FCA are proceeding with the proposal that any portion of an anti-dilution benefit that would lead to negative transaction costs should be disregarded to prevent negative transaction costs from being disclosed.

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. The FCA believe that this should avoid the possibility of firms calculating negative transaction costs for such transactions.

Calculation of transaction costs for index-tracking funds

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

Understanding the average price of transaction costs

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.

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