ESAs find structured product and derivative KIDs non-compliant and mandate changes

Summary

• On 9 May 2022, the European Supervisory Authorities published a supervisory statement on their expectations as regards the "What is this product?" section of KIDs.
• The statement warns that many KIDs - particularly those prepared in respect of structured products and derivatives - are not compliant with the PRIIPs Regulation¹. 
• The ESAs found that KIDs are overly technical and fail to meet the "clear, succinct and comprehensible" requirement.
• At the same time, they consider that KIDs are too generic, and do not adequately describe the type of PRIIP, its objectives, and the type of investors to whom it is to be marketed.
• Leveraged PRIIPs, such as "turbos", and PRIIPs with a "custom" (or "proprietary") index are a particular concern.
• The fact that a KID is produced by way of automation and/or that the PRIIP is particularly complex does not excuse the use of overly generic language.
• Depending on the product and the manufacturer, the ESAs' statement may require substantial changes to EU KID templates.

Non-compliant KIDs

Following closely on their comprehensive review of the PRIIPs Regulation and current market practice_², the ESAs have determined that many KIDs are not PRIIPS Regulation-compliant, largely because they do not include sufficient information or detail for the potential investor to fully understand the product.

The statement is expressed as being applicable to all PRIIPs, but the treatment of certain product features that are only relevant for structured products and derivatives, such as autocall features, early termination provisions, and leverage factors, is singled out for particular criticism.

The statement includes several examples of acceptable and unacceptable drafting, with related commentary offering additional feedback. 

"What is this Product?" - key areas of focus

The free-text "What is this product?" section is the first descriptive section of a KID, and is described by the ESAs as an "essential part of the document to enable retail investors to understand the key features of the product". It is intended to cover five areas:

1. the type of the PRIIP;
2. the PRIIP's objectives and the means for achieving them;
3. the term of the PRIIP; 
4. a description of the intended retail investor; and
5. details of any insurance benefits.

In the statement, the ESAs address the first four of these areas. 

Type

The statement notes that certain types of PRIIPs are described narrowly with reference to their legal form – for example, "debt instrument", "debt obligation", or "note" - despite having very different features. Examples given include mortgage bonds, structured notes (non-leverage products) and leverage products such as turbos and turbo warrants. The ESAs have determined that, although such a description of the type of PRIIP might be legally accurate, it is not adequate for KID purposes. The ESAs feel that the following information should be included in the KID with regard to the type of PRIIP:

• the legal form of the PRIIP, choosing the (legal) terminology that best represents the nature of the product, and specifying it further to the extent possible;
• an indication that the return on the product depends on the performance of the underlying asset(s) (where applicable); and
• whether or not the product is capital protected, and the degree of any such protection.

Manufacturers of structured products may be wary of using the terms "capital protection" or "capital protected" where the product is unsecured, though this may be mitigated by including a statement to the effect that any protection is limited to market risk and does not protect against credit or insolvency risk of the issuer.

This appears to be a broad reading of the word "type" by the ESAs. However, in some cases the practical impact for PRIIP manufacturers may be limited to simply relocating text from the "Objectives" sub-section to the "Type" sub-section of the KID.

Objectives

The ESAs consider that the "Objectives" sub-section of the KID must describe the main features of the PRIIP and explain them in a way which is not overly generic and in a format that is concise and easy to read. The ESAs have observed that the marketing materials of a particular product are often of much higher quality than the KID – including the use of bespoke text for the main features - implying that a more manual approach for KIDs is feasible. The ESAs have also noted that the language used in KIDs can be too technical and difficult to understand and at the same time be overly long and complex, and thus fail to be sufficiently clear and comprehensible.

For purposes of the "Objectives" sub-section, the ESAs effectively consider the "main features" of a product to be:

• the way in which it works and its aim, its risk/return profile (for example, capital protected; yield enhancement);
• the possibility of early redemption (autocallability); 
• liquidity conditions (for example, any relevant exchange listing or secondary market trading); and
• the extent of any capital protection and/or guarantee schemes.

The ESAs have provided specific content guidance, including examples of non-compliant and recommended text, which is discussed below.

Capital protection; potential losses; payoffs

For products that are not 100% capital protected, the scenario(s) that would lead to a loss and the potential amount of loss must be explicitly described. Payoffs should not be left to the potential investor to infer or calculate from a formula.

Autocall and contingent coupon features

Any early redemption feature should be indicated prominently in the "Term" sub-section of "What is this product?", and also potentially at the very beginning of the "Objectives" sub-section.

Autocall and contingent coupon formulas must not be overly generic or technical: while incorporating a table of data and definitions is acceptable, the main description of the autocall and coupon payout should use simple language and blend in key data where possible, so that the investor can readily understand the feature without having to read it with the definitions and/or data table. 

This requirement is likely to prove challenging for products incorporating autocall and payout features with variables on both trigger and payout, and in particular for automated KIDs.

Early termination: "main events"

The overarching requirement is that, while it may not be possible to include details about every possible termination or adjustment event, the potential investor should be able to understand from the KID what are the main events that could give rise to a unilateral termination or adjustment, and its impact on the investment. An explanation should be given of the main events that could lead to an unscheduled early termination or adjustment, such as delisting. 

To date, many PRIIP manufacturers have only included a generic description of the extraordinary events which may lead to early termination or adjustment, and therefore satisfying this requirement will entail additional detail being added and further space taken up in the KID.

Underlying asset(s), including if a custom index

The ESAs note that information provided in respect of the asset(s) underlying a structured product or derivative PRIIP is often insufficient, particularly where the underlying is a custom, or proprietary, index. 

In particular, the ESAs have determined that PRIIP manufacturers should specify not only the nature of the asset (share, bond, commodity etc.), but also the asset's "business sector", to "allow retail investors to evaluate the product's aim and to identify the drivers of its performance".

If the underlying asset is a custom index, the ESAs are of the view that as custom indexes use more or less complex rules to select the components to invest in, and are generally based on a theme and on financial filters and weighting schemes, these must be described in the KID in order for investors to understand the economic rationale of the product.

While it is perhaps not surprising that the ESAs have raised concerns as to the disclosure around custom indexes given the different approaches in the market, in many cases it may simply not be feasible to provide the required information within the three page limit.

Leverage factor – e.g. turbo products

In their statement, the ESAs have noted feedback from national competent authorities that in several cases the KIDs of leveraged products do not offer enough information about the relationship between the payoff of the product and the underlying asset, and about the dynamic or constant nature of the leverage factor, its value (or maximum value if dynamic), and the factors that underpin its variability.

Intended retail investor

The ESAs note that national competent authorities regard the description of target retail investors in many KIDs to be "too high level and abstract", possibly as a result of the automation process. They state that the description be product-specific, and that, in particular:

• the intended investment horizon should be specific, for example "very short", "short", "medium", and so on, or should specify a specific number of years of investment deemed compatible with the product;
• if there is a reference to the Summary Risk Indicator, it should not be a generic cross-reference but should mention the actual SRI score; and
• there should be a specific reference to the capacity to bear issuer credit risk, as well as market risk, where applicable.

Increased scrutiny?

It is clear from the statement that the ESAs consider many KIDs in the market to be non-compliant. The statement is addressed to EEA national competent authorities and is expressed to have been issued with a view to "promoting a level playing field and the protection of retail investors". This would suggest that the market may begin to experience increased levels of scrutiny from competent authorities as regards KIDs.

UK position

Absent any regulator comment to the contrary, UK market participants are outside the scope of the ESAs' statement (although affected market participants may wish to confirm with the FCA its view on the statement). In any event, for entities that issue PRIIPs both in the EU and the UK, it would seem prudent, and more straightforward operationally, to generally follow the guidance for all products. Separately, UK manufacturers will be required to change their KID templates from 1 January 2023 to ensure compliance with the newly amended UK PRIIPs regime.

Next steps

Given the impact that the ESAs' statement is likely to have on a broad section of the market, interested parties and trade bodies are likely to seek clarifications from relevant competent authorities, which may ultimately issue additional, jurisdiction-specific, guidance. Also, the ESAs have not ruled out the possibility of supplementary guidance being issued in respect of other sections of the KID in due course, and further changes may stem from the Commission's review of the EU PRIIPs framework later this year. Notwithstanding these potential future developments, given the broad scope of the deficiencies identified in the statement, and the statement's immediate application, market participants may wish to review their current KID practices in light of the ESAs' guidance and address any deficiencies as a matter of some urgency. 

Authors: Mike Logie, Partner; and Kirsty McAllister-Jones, Expertise Counsel.

_{1. EU Regulation 1286/2014}

_{2. Call for advice on PRIIPs: ESA advice on the review of the PRIIPs Regulation. 29 April 2022}