Liability and enforcement
Territorial scope of regulations
What is the territorial scope of the laws and regulations governing listed, cleared and uncleared equity derivatives transactions?
The United Kingdom laws and regulations applicable to trading in equity derivatives typically apply to participants irrespective of their location, if their conduct or the financial instrument has a nexus with the United Kingdom.
The United Kingdom laws and regulations applicable to issuers of shares apply by virtue of such issuer being incorporated under the Companies Act 2006 (CA 2006) or such shares being admitted to trading on a trading venue in the United Kingdom.
Registration and authorisation requirements
What registration or authorisation requirements apply to market participants that deal or invest in equity derivatives, and what are the implications of registration?
MiFID II and MiFIR introduced a requirement for certain declared types of the most liquid and standardised derivatives to be traded on a trading venue in the EU, rather than OTC. In addition, where this requirement applies to a class of derivatives, certain price transparency obligations will also apply. The requirement applies to financial counterparties and certain types of non-financial counterparties, as defined in EMIR; however, to date, only certain types of interest rate and credit derivatives have been declared to be subject to this obligation.
Unless an exemption or exclusion applies, EMIR (as amended by the EMIR Refit Regulation) applies to all OTC derivative transactions (including equity derivatives) and imposes requirements for transactions to be reported to regulators and either cleared or, if the clearing obligation does not apply to a particular class of derivative transaction, subject to other risk mitigation techniques (including trade confirmation, portfolio reconciliation, daily marking-to-market, exchanging initial or variation margin and capital requirements for financial counterparties). The extent to which these obligations apply depends in part upon the nature of parties to the derivative transaction. EMIR distinguishes between financial counterparties (broadly, regulated entities, which would include most dealers) and non-financial counterparties (broadly, any undertaking established in the EEA that is not a financial counterparty) and imposes the most onerous obligations where OTC derivatives transactions are entered into between financial counterparties or between a financial counterparty and a non-financial counterparty whose derivative trading activity exceeds a prescribed notional value (an NFC+), unless an exemption or exclusion applies. EMIR also applies where a financial counterparty or NFC+ enters into an OTC derivative transaction with an entity established outside of the EEA if that entity would be a financial counterparty or an NFC+ if it were established within the EEA. EMIR can also apply to OTC derivative transaction between two such non-EEA entities if that transaction has a ‘direct, substantial and foreseeable effect’ within the EEA or where necessary to prevent evasion of any provision of EMIR.
MAR established a common regulatory framework on market abuse across the EU and prohibits inside dealer, unlawful disclosure of inside information and market manipulation. It applies to conduct anywhere in the world if it relates to financial instruments within the scope of MAR. The financial instruments to which MAR applies are very broad and include (without limitation) securities (including depository receipts) that are admitted to trading on a trading venue in the EU and other instruments the price or value of which depends on or has an effect on the price or value of such securities. Accordingly, broadly speaking, equity derivatives are within the scope of MAR.
What reporting requirements apply to market participants that deal or invest in equity derivatives?
There are a number of reporting obligations for an issuer or shareholder of an issuer when entering into OTC equity derivatives transactions in respect of the shares in the issuer. These include:
- trade reporting obligations under MiFID II, MiFIR and EMIR;
- notifications of any dealings in shares of an issuer by a person who discharges managerial responsibilities within that issuer (and persons closely associated with them);
- notifications when an issuer repurchases its own shares; and
- disclosure of substantial shareholdings, control of voting rights and economic long positions as required by the Disclosure and Transparency Rules (DTRs).
Additional disclosure obligations may apply in specific circumstances, including when a public offer is or has been made in relation to the shares of the issuer and where the issuer is a regulated institution or part of a sensitive industry.
An issuer that has financial instruments admitted for trading on a regulated market (or for which a request for admission for trading has been made) is further required to disclose, as soon as possible, all inside information that directly concerns the issuer.
Subject to certain exemptions, the DTRs require a person to notify the issuer and the FCA of any active or passive acquisition or disposal of voting rights (or deemed acquisition or disposal of voting rights) that results in that person’s holding (or deemed holding) of voting rights reaching, exceeding or falling below certain threshold percentages of the total voting rights attaching to the issuer’s issued share capital. As a practical matter, this notification obligation applies to acquisitions and disposals of already issued shares (to which voting rights are attached) and also to acquisitions and disposals of derivatives (and other instruments) that create either an unconditional entitlement to receive shares (to which voting rights are attached) or an economically equivalent position. As a consequence, long positions via derivatives – whether cash or physically settled – are potentially notifiable.
The notification thresholds apply when holdings of voting rights reach, exceed or fall below:
- in the case of UK issuers: 3 per cent and each 1 per cent thereafter; and
- in the case of non-UK issuers: 5, 10, 15, 20, 25, 30, 50 and 75 per cent.
To calculate the notification threshold, all holdings of shares and other relevant instruments are aggregated. Long positions held via cash-settled options are calculated on a delta-adjusted basis, but otherwise long positions held via derivatives are calculated on the full number of underlying shares.
The notification requirement may also be triggered by passive movements through these thresholds (for example, where a company purchases its own shares and the person’s shareholding is concentrated as a result). The obligation on the person dealing in the shares is to notify the issuer and this creates an obligation on the issuer to notify the market.
The notification requirement is subject to a number of exemptions. The exemptions most commonly relied upon by dealers in the context of OTC equity derivatives are the market-maker exemption (which, subject to certain conditions, allows the dealer to disregard its holdings until they reach 10 per cent) and the trading book exemption (which, subject to certain conditions, allows the dealer to disregard holdings in its trading book until they exceed 5 per cent).
What legal issues arise in the design and issuance of structured products linked to an unaffiliated third party’s shares or to a basket or index of third-party shares? What additional disclosure and other legal issues arise if the structured product is linked to a proprietary index?
Certain entities that manufacture (ie, create, develop, design or issue) or distribute (ie, offer, recommend, or sell) financial instruments and structured products such as securitised derivatives and structured notes from an establishment or appointed representative in the UK must comply with the Markets in Financial Instruments Directive (2014/65/EU)/Markets in Financial Instruments Regulation (600/2014) (MiFID II/MiFIR)-derived product governance, namely, rules set out in the Product Intervention and Product Governance Sourcebook (PROD) and the Conduct of Business Sourcebook (COBS). The PROD and COBS comprise part of the Financial Conduct Authority (FCA) Handbook.
The product governance rules apply to MiFID investment firms (ie, regulated entities to which MiFID II/MiFIR applies) and branches of third-country investment firms that would be a MiFID investment firm if they were headquartered in the EEA. In addition, other firms that manufacture or distribute financial instruments or structured products (but are not MiFID investment firms) must take into account the product governance rules as if they were guidance in the Principles for Businesses in the FCA Handbook.
The product governance rules apply proportionately and may be more onerous if structured products are offered to retail investors, as defined in MiFID II. The product governance rules apply to UK MiFID-investment firms’ business activities in the UK or EEA, irrespective of whether the investors are in the UK, the EEA or elsewhere. If a manufacturer or distributor is involved in marketing the products, then it may also need to be authorised under the Financial Services and Markets Act 2000 (FSMA).
The product governance rules require manufacturers to have product approval and review processes in place to, among other things:
- identify with sufficient granularity a target market with the end client in mind;
- ensure that the product is designed to meet the needs of the identified target market;
- ensure that the distribution strategy is compatible with the target market;
- communicate target market and distribution strategies to distributors; and
- conduct regular reviews (at least annually) during the life of the product to ensure that the product and distribution channels remain appropriate for the identified target market.
Distributors must obtain target market and distribution information from manufacturers and assess the appropriateness of financial instruments or structured products for their individual clients and communicate any changes to their distribution strategies.
If financial instruments or structured products are admitted to trading on a regulated market in the EEA or offered to more than 150 non-qualified investors, the issuer must prepare a prospectus (subject to limited exceptions) in accordance with the Prospectus Regulation (Regulation No. 2017/1129). Manufacturers and distributors must also provide a key information document (KID) before structured products can be offered to retail investors in the UK. The form and content of a KID are highly prescriptive and must meet the requirements of the Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation (Regulation No. 1286/2014). The obligation to provide a KID to retail investors in the UK applies to all manufacturers and distributors, including third-country entities and entities that are not MiFID investment firms.
If the structured product references a proprietary index and the product is traded on a trading venue or via a systematic internaliser, the product manufacturer must comply with the Benchmarks Regulation (Regulation No. 1011/2016) (BMR), which regulates the provision and use of benchmarks, as well as the contribution of input data to benchmarks. In this context, ‘use of a benchmark’ includes issuance of a financial instrument that references an index or a combination of indices, or determination of the amount payable under a financial instrument by referencing an index or combination of indices. In addition, recent amendments to the BMR impose specific requirements in respect of ‘EU Climate Transition’ and ‘EU Paris-aligned’ benchmarks relating to climate change and sustainability. The BMR only applies to financial instruments that are traded on a trading venue (or in respect of which a request for admission has been made) or via a systematic internaliser, as well as certain credit agreements and investment funds.
The BMR contains transition provisions, under which benchmark administrators may continue to provide, and supervised entities may continue to use, certain non-compliant benchmarks. In the case of critical and third-country benchmarks, the transition period applies until 31 December 2021.
Describe the liability regime related to the issuance of structured products.
There is a range of statutes containing provisions relating to misleading statements made in offering documentation. There may also be additional common law liability. The relevant statutes include the following:
- the Fraud Act 2006 provides that fraud will be a criminal offence, and this includes dishonestly making a false representation with an intention of making a gain or causing a loss, and dishonestly failing to disclose information where there is a duty to disclose it (with an intention of making a gain or causing a loss);
- section 89 of the Financial Services Act 2012 provides that it is a criminal offence to make statements that are false or misleading in a material respect, which section 90 contains prohibitions on giving misleading impressions;
- the FSMA sets out criminal and administrative sanctions and enforcement procedures for failing to comply with the FSMA’s requirements, along with obligations arising under other statutes such as the Prospectus Regulation, the Market Abuse Regulation (596/2014) (MAR) and Securitisation Regulation;
- the Enforcement Guidance (EG) Manual in the FCA Handbook describes the FCA’s approach to exercising its main enforcement powers under the FSMA and other legislation; and
- the EG Manual also grants the FCA the power to require restitution to remedy harm to investors caused by non-compliance of their statutory obligations.
The FSMA also provides a scheme of civil liability, which includes matters such as the standard of conduct and defences. For example, sections 20(3), 71(1) and 71(2) FSMA include potential civil remedies under breach of statutory duty in respect of the carrying out of controlled activities under FSMA. Section 90 FSMA creates a civil liability regime in respect of statements in listing particulars or prospectuses by creating a right to obtain compensation for any person who has acquired securities to which the particulars apply and suffered a loss as a result of any untrue or misleading statement in the particulars or the omission of any required information. Under section 138(D)(2) FSMA, a contravention by an authorised person of a rule made by the FCA is actionable at the suit of a private person who suffers loss as a result of the contravention, subject to the defences and other incidents applying to actions for breach of statutory duty.
What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is convertible for shares of the same issuer?
A number of issues arise in the context of a convertible bond issue, some of which are applicable to the issuer and some to investors.
The issuer needs to ensure it has the necessary authority to allot new shares and consider whether any restrictions exist on its ability to do so, whether in its articles of association or at law. In addition, the issuer must consider how it intends to deal with pre-emption rights given to existing shareholders, which allow them what is effectively a right of first refusal over any new shares being issued. There are a number of structural methods of dealing with pre-emption rights, which generally depend upon the intended number of new shares to be allotted in connection with the issuance of convertible bonds.
Convertible bonds are usually listed eurobonds, so the FCA listing rules for convertible securities will need to be complied with in addition to the rules of the exchange on which the underlying shares are listed to achieve and maintain the listing of the convertible bonds and the underlying shares. If the convertible bonds or the underlying shares are offered to the public and admitted to trading on a regulated market (such as the London Stock Exchange Main Market) or another relevant trading venue (such as the London Stock Exchange Professional Securities Market), then the FSMA, MiFID II, MiFIR and MAR will all be applicable. In addition, the disclosure obligations will differ depending upon the exchange on which the convertible bonds are listed. For example, if the convertible bonds are to be listed and traded on the Main Market, the FCA’s Prospectus Regulation Rules will require the issuer to publish a prospectus. The level of disclosure required in the prospectus depends on the denomination of the convertible bonds and whether the issue falls under the wholesale regime or retail regime. By contrast, the Professional Securities Market does not require a prospectus to be issued but will require listing particulars to be prepared and approved by the FCA.
A number of tax issues arise in the context of a convertible bond. Withholding tax and capital gains tax will be a consideration, as will the application of stamp duty and stamp duty reserve tax. The nature, location and identity of the bondholders (and whether the bondholder is considered to be connected to the issuer for tax purposes) will also be relevant to the assessment of direct taxes for both the issuer and the investors.
What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is exchangeable for shares of a third party? Does it matter whether the third party is an affiliate of the issuer?
Exchangeable bonds typically involve the bonds being exchangeable into shares that are owned by the bond issuer but were issued by a company that is not a bond issuer. As a consequence, because the bond issuer will not be allotting or issuing new shares in itself, some issues are not relevant, such as the requirements for authorisation for and restrictions on allotting new shares and pre-emption rights.
However, as most exchangeable bonds will be listed eurobonds, the FCA’s requirements regarding listing and disclosure will need to be complied with if the bonds are to be listed on the London Stock Exchange.
A number of tax issues arise in the context of an exchangeable bond. Withholding tax and capital gains tax will be a consideration, as will the application of stamp duty and stamp duty reserve tax. The nature, location and identity of the bondholders (and whether the bondholder is considered to be connected to the issuer for tax purposes) will also be relevant to the assessment of direct taxes for both the issuer and the investors.
Law stated date
Give the date on which the information above is accurate.
1 July 2020
This article is made available by Latham & Watkins for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. Your receipt of this communication alone creates no attorney client relationship between you and Latham & Watkins. Any content of this article should not be used as a substitute for competent legal advice from a licensed professional attorney in your jurisdiction.