Disclosure Practices in Unregistered Structured Product Offerings

Introduction

There are different types of "wrappers" that are typically used for U.S. offerings of structured products. For example, an offering may take the form of a registered public offering, a bank certificate of deposit, an unregistered bank note offering under Section 3(a)(2) of the Securities Act, or an offering sold to "qualified institutional buyers" under SEC Rule 144A. The required disclosures, and the amount of disclosures, in the offering documents for these transactions differs from wrapper to wrapper, based on the relevant regulations and market practice. However, due to the expectations of investors and structured product dealers, there is also a healthy amount of overlap, particularly among products intended for retail investors.

This article discusses some of the disclosures that are unique to the structured products industry as a whole, and how they are typically treated in different types of offering wrappers.¹

Estimated Value Disclosures

As a result of the SEC's 2012 "structured note sweep letter" and follow-up discussions with industry participants, the offering documents for most types of SEC registered structured notes now include robust disclosures as to the issuer's calculation of each product's estimated value, and related risk factor disclosure. This estimated value is typically stated as a range, or as a floor, in a red herring, and is followed up in the final offering documents with a final value calculated as of the trade date. The estimated value is typically less than the purchase price due to underwriting fees and the cost of hedging the issuer's exposure to the product. In the "sweep letter" and related follow-up, the SEC determined that this information was material to investors since it helps explain the relationship between the purchase price and the fair value of the product, and therefore, required disclosure under its rules and regulations.

These disclosures are not technically required for non-registered offerings. However, in the context of retail offerings of non-registered structured bank notes and structured CDs, these disclosures are typically included, and issuers utilize a comparable process for effecting the relevant calculations on the pricing date. This development largely results from the fact that these types of unregistered instruments are often distributed by the same broker-dealers that distribute registered structured notes, and are often offered to a comparable pool of investors. Accordingly, the relevant distributors seek a somewhat uniform treatment on estimated value disclosures in order to satisfy the expectations of their representatives and customers, and to enable their customers to compare one product to another.

However, these disclosures are almost uniformly excluded from Rule 144A offerings, which are sold to large "qualified institutional buyers." In Rule 144A offerings, not only is the information not required by any SEC rule, but the relevant investors are typically as capable as the issuer of calculating the estimated value of a particular instrument.

Risk Factor Disclosures

In the context of registered structured notes, the "Risk Factors" section(s) of the offering documents is a critical piece of the disclosure package. There is limited SEC guidance as to what the content of this section should be for a typical structured note, but a substantial body of market practice has emerged, which contemplates fairly robust disclosures about, for example, the relevant economic terms of the notes, risks relating to the linked asset, and relevant taxation issues.

These disclosures tend to be maximized in the case of registered notes, where the stakes are highest: retail investors are involved in the offerings, the SEC and FINRA have actively reviewed practices of market participants, and the documents are publicly available through the SEC's electronic filing system.

Market participants tend to follow a similar practice of including robust risk factor disclosures in connection with structured certificates of deposit and unregistered bank notes. In this context, concerns about liability are at the forefront, in particular due to the participation of retail investors in these offerings. And since many of these offerings are sold to the same pool of investors as registered notes, distributors tend to prefer to have comparable disclosures.

Risk factor disclosure practices are more varied in the Rule 144A context. As a general rule, most market participants tend to seek to have the set of risk factors contemplated by the entire "disclosure package" (i.e., pricing supplement plus base documents) have a comparable scope as is used in the registered context, in order to address potential liability concerns. However, in the Rule 144A context, issuers tend to be more likely to place some or many of the relevant risk factors in the base offering documents for their offerings, as opposed to the offering-specific pricing supplements. Some issuers may be also more likely to omit some of the non-product specific, "generic" risk factors that professional investors are well familiar with. Additionally, some issuers do not include risk factors relating to the underlying asset, if information relating to the underlying asset is publicly available, such as a non-proprietary index or an ETF, based on the theory that sophisticated investors are capable of independently accessing this information and assessing the relevant risks on their own. In fact, 144A investors often sign a letter of representations deliverable to the issuer that affirms, among other things, that the investor has all information it needs and it is not relying on the issuer to assess the risks relating to the underlying asset. In short, disclosure practices are more varied in this segment of the market.

Linking to Non-U.S. Stocks

The SEC's 1996 "Morgan Stanley" no-action letter²  sets forth the SEC's standards for when an issuer may link a structured note to a particular stock while setting forth only limited disclosures relating to that underlying stock.³  The no-action letter sets forth a number of requirements, including that the relevant underlying company have equity securities that are registered in the U.S. under the Securities Exchange Act of 1934, and certain qualifications relating to its market capitalization and/or trading history. Due to these requirements, structured notes are rarely issued in registered offerings that are linked to the performance of a stock that does not trade in the U.S. (unless that stock is, for example, a component of an equity index).

Although there is no rule that requires similar treatment, most retail offerings of structured CDs and registered bank notes follow similar standards relating to underlying stock selection. This is principally driven by market demand – U.S. investors, especially retail investors, tend to have limited interest in investing in offerings linked to individual non-U.S.-traded stocks. In addition, many distributors have their own business and due diligence standards that are used to determine which stocks they may offer as underlying assets, and these standards often track to a large extent the requirements that are applicable to registered offerings.

In the Rule 144A context, issuers and distributors are not so limited. In fact, Rule 144A offerings of structured notes are one means by which U.S. institutional investors obtain economic exposure to non-U.S. stocks, without the need to effect transactions on a non-U.S. exchange. In addition, the institutional investors that invest in these offerings do not need the disclosure protections of the SEC rules in the same way that retail investors arguably need them. Accordingly, Rule 144A structured notes are frequently linked to non-U.S. stocks that are not registered in the U.S.

Disclosures Relating to Underlying Assets

Similar questions arise in terms of how much disclosure is provided in the relevant offering documents about the underlying asset, whether that asset is, for example, an index, an ETF or a single stock. With the exception of the limited information about individual stocks required by the Morgan Stanley no-action letter, there are no specific SEC rules that govern how much information needs to be disclosed about an underlying index or ETF. As a result, the dominant market practice in registered offerings of index-linked and ETF-linked notes is to provide in the relevant offering documents a somewhat robust description of such an underlying asset and its methodology.

In the context of certificates of deposit and unregistered bank notes, for these types of underlying assets, issuers tend to utilize comparable disclosures (and any related risk factors) as they do in the context of registered offerings. This practice is largely observed out of liability concerns – issuers are attempting to provide to the investors in these products the same amount of information as they would in a registered offering. Or, put another way, if the information is deemed sufficiently material to be included in the offering documents for a registered offering, it is also included in these types of non-registered offerings.

Market practice is more varied in the context of Rule 144A offerings. Generally speaking, the scope of disclosures about an underlying asset is reduced in these offerings. For example, many issuers of Rule 144A notes linked to individual stocks do not include the short disclosures about an underlying issuer's business that would be included under the Morgan Stanley no-action letter in a registered offering. That is because many of these offerings are reverse inquiry transactions, in which the institutional investor has access to all of the relevant issuer's public filings, and does not need the relatively limited information that could be provided by the issuer of the structured note. In addition, a typical letter of representations delivered by an institutional investor, as described above, states the investor is not relying on the issuer for information about the underlying asset. Rule 144A offering documents may also provide less information about linked indices and ETFs than do their SEC-registered analogs.

Historical Underlying Asset Performance

One of the requirements of the original Morgan Stanley no-action letter that applies to registered offerings was the inclusion of historical price information for the relevant stock in the offering documents for the structured notes. (However, the Morgan Stanley letter achieved this through a cross-reference to an SEC rule, Item 201(a)(1) of Regulation S-K, for issuer annual reports which no longer exists, because the SEC subsequently determined that investors can obtain historical price information on stocks from publicly-available resources, such as most finance and investment websites.⁴) In any event, most offering documents for registered structured notes include a graph and/or a table setting forth the historical performance of the relevant underlying asset, typically for a period of five to 10 years.

Offering documents for structured CDs and unregistered bank notes tend to include information that is comparable to their SEC registered brethren. These products often have a common investor base as registered public offerings; accordingly, issuers and distributors attempt to promote the uniformity of their disclosures on this point. In addition, at least some investors prefer to have the convenience of the historical performance set forth in the offering document itself, instead of having to look it up on-line or otherwise. The presentation in a prospectus may also be helpful to investors to demonstrate the potential performance of a product, such as where the issuer provides an indication in the relevant historical graph indicating where the particular buffer level or barrier level for an offering would fall, based on the latest market price and historical performance.

However, in Rule 144A offerings, this historical disclosure is typically omitted. These transactions are often reverse inquiry transactions, in which the relevant investor helped set the terms of the offerings based in part on the known historical information about the relevant underlying asset. And again, in this context, institutional investors typically do not need this information, which is easy to access from a PC or a Bloomberg terminal.

U.S. Tax Opinions

SEC Staff Bulletin No. 19⁵ sets forth the SEC's position that, where the tax consequences of a particular transaction are material to investors, a tax opinion must be set forth that discloses the name of the relevant tax counsel. If, for example, there is a lack of authority directly addressing the tax consequences of the transaction, the opinion may be a “should” or “more likely than not” opinion.

Issuers tend to apply somewhat similar U.S. tax disclosures in context of offerings of structured certificates of deposit and unregistered bank notes. Doing so helps to ensure that investors can compare similar products to one another. However, in some cases, the specific tax counsel is not identified in these unregistered offerings, in an effort to reduce the potential liability for the law firm that is responsible for the disclosures.

The treatment of the tax disclosure in Rule 144A offerings varies. At one end of the spectrum, the disclosures can be quite similar to those of registered offerings. At the other end of the spectrum, a letter of representations delivered by the institutional investor may have the investor represent that it will conduct its own review of the tax consequences of the offering – in such a case, for example, it is possible that no disclosure relating to the U.S. tax consequences will be included in the relevant offering documents.

Validity Opinions

Staff Bulletin No. 19 also requires corporate law opinions relating to the validity of the securities to be included in the document suite for registered offerings. For most issuers, this has led to a process in which a short form legal opinion is added (typically at the very end) of the final pricing supplements for registered structured notes.⁶

In light of the limited utility to investors of this information, the practice is not followed for unregistered bank notes and Rule 144A offerings, or in the case of structured certificates of deposit. In the context of SEC-registered offerings, it is provided due to the technical application of the relevant rules. However, in unregistered offerings, the relevant underwriters typically receive enforceability opinions from issuer's legal counsel at the outset of a program and in connection with periodic updates to that program. The offering documents themselves do not address these issues.

Other author: Brandon Chesner, Junior Associate