A Testing Time For Europe’s PRIIPs Regime

Funds industry awaits clarity from European institutions

Originally published in the September 2016 issue

PRIIPs is an acronym for Packaged Retail Investment and Insurance Products. It represents a cross sector initiative, affecting asset managers, insurance companies and banks, aimed at creating a new standard common disclosure document for retail investors. The premise of the legislation, besides supporting the European single market, is to enhance comparability of PRIIPS with UCITS funds and the overall comprehensibility of financial products for retail investors – as highlighted in the explanatory works to the proposal of the European Commission – through a standard pre-contractual disclosure that is the same across the various sectors and product types.
The PRIIPs legislation is undoubtedly amongst the most ambitious regulatory efforts in recent memory and, in some respects, also one of the most innovative pieces of financial services legislation currently under works at a European level. We are also now witnessing how it is becoming one of the most debated ones. In fact, the PRIIPs regime was created through a regulation, which dates from 2014, as well as regulatory technical standards as delegated regulation. The topic of PRIIPs has been heavily prevalent in the news during the past number of weeks because the process of adoption of PRIIPS legislation has been halted by a group of members of the European Parliament, which have managed to gain the support of the Parliament in rejecting the proposed level 2 legislation, which covers the Regulatory Technical Standards (RTS).

Whilst we have already seen in the recent past how other pieces of financial services legislation have been delayed (MiFID II), it is not yet set in stone that the same outcome will be the case in relation to the PRIIPs legislation. On the one hand, the two initiatives (MiFID and PRIIPs) are deeply intertwined in some respects, and product manufacturers as well as distributors, who are the ones in charge of producing the KID, might benefit from an alignment of the timeline of both initiatives. On the other hand, however, there might be other forces in the market driving an adoption on time of the PRIIPS legislation, be it with a corresponding suite of level 2 principles or not.

What is a PRIIP and who is concerned with the initiative?
The definition PRIIP is applicable to two sets of different products: a) the Packaged Retail Investment Product, which is any product, irrespective of the legal form, where the repayment can fluctuate due to its linkage to reference values or performance of underlying assets, not directly purchased by the retail investor; as well as b) insurance-based investment products.

It is noteworthy that the regulation only applies in conjunction with products sold to retail investors; hence products offered only to institutional investors are not covered by the regulation.

The regulation and the production of the PRIIPS KID are the responsibility of the manufacturers, who either create the PRIIP or make any changes to a PRIIP that may alter the risk and reward profile as well as the cost of the investment, as well as the distributors.

As we have seen very frequently in the recent years with regulation within financial services, existing concepts, already in place and applied for years to certain products, are adapted constantly to new scenarios, so as to capitalise and leverage on the proven success in pursuing the aims of the European Union. This is not only for the sake of regulatory convergence, but also to facilitate an improvement of existing approaches, with the PRIIPS KID sharing similarities with the UCITS KIID.

Impact on the UCITS KIID
The correlation between the PRIIPs KID and the UCITS KIID is inevitable and the PRIIPs regulation accordingly addresses from the outset a few of the issues that were dealt with already with the UCITS KIID. As such, there are provisions related to the periodical update of the PRIIPS KID, translation as well as notification requirements for host state regulators, unless these are eased as part of the pursuit of a Capital Markets Union.

Whilst the PRIIPs KID is to be considered as a pre-contractual document, the regulation introduces a concept of “good time” in advance for the retail investor to receive the document. This is a rather vague indication, as it was also dealt with in the RTS, and will most probably receive further specification by ESMA in the Level 3 regulation and Q&A.

As many readers may know already, UCITS also fall under the definition of PRIIPs, but have been grandfathered from the production of the PRIIPs KID until December 2019. However, whilst there is currently no option for UCITS opting into the KID for PRIIPS regime prior to this date, there might be situations where a UCITS could be required to deliver data (provided in accordance with the guidelines and methodologies of the new PRIIPs regime) or in some cases even be required to produce a PRIIPS KID before the grandfathering is over. In fact, if we consider the case where UCITS are sold via unit linked insurance products, for instance, there will be an obligation to deliver data, or in some countries, produce a KID for PRIIPS also for the underlying investment, the UCITS fund in this case. So there will be cases whereUCITS funds must deliver data or produce both a KIID and a KID.

Some local jurisdictions, such as Denmark, have granted UCITS funds offered via unit linked solutions an exemption from producing a KID.

In the UK, no real exemption is being granted, especially to non-UCITS retail schemes – NURS – which as at today will have to produce a PRIIPs KID by the December 2016 deadline, unless this is either pushed back or the FCA decides to extend to all NURS the requirements of the NURS key investor information, which is similar to the UCITS KIID, thus enabling them to avail of the grandfathering period provided for UCITS KIIDs.

In a Nordic context we also already see current local jurisdictions making their own interpretations of the level 1 legislation within the current environment, for example in Sweden and Finland, where UCITS funds are being asked to produce a truncated version of the KID for PRIIPs (referred to by some as a “Baby KID”) when the funds are wrapped within unit linked solutions. This approach contradicts the overall European approach, where UCITS funds will be required to provide PRIIPs compliant data in order to facilitate the production of the KIDs on the part of the manufacturers who invest in their products.

Criticism of the RTS expressed by EFAMA
EFAMA, the European Fund and Asset Management Association, has already, on different occasions now, expressed its scepticism about the process of implementation of the PRIIPs legislation currently followed and its foreseeable results in the short term.

In a first statement, dating back to February this year, EFAMA advocated in support of a delay of the implementation of the PRIIPs directive, in respect of the December 2016 deadline, so as to allow for sufficient time to implement the regulation. Also, in a later statement released immediately after the final draft of RTS was published, EFAMA again manifested perplexity on the success of the initiative on some respects.

EFAMA used a comparative approach with the UCITS KIID regulation and consequently focussed on a few of the lessons that can be learnt from there. More specifically, EFAMA believed, for instance, that the methodology proposed to present costs, would fail in allowing investors to effectively compare different investments the way it was proposed to be implemented. In fact, EFAMA argued that currently costs in the PRIIPs KID are shown only in their compound effect of each cost component and not also as summary indicator. This approach would not allow investors to compare the real cost of the investment at each stage they enter, hold and exit. An entry charge cost, for instance, of 3% would be indicated as 0.62% over the recommended five year holding period, thus frustrating the main aim of the regulation to enhance comparability amongst PRIIPs, UCITS included (where the cost figure is not adjusted per the recommended holding period).

EFAMA welcomed the vote of the European Parliament to halt the adoption of PRIIPS level 2 legislation and reinstated its belief that the principles underpinning PRIIPs level 1 legislation are valid and in the interest of consumers. EFAMA would not want to reopen discussion on PRIIPs level 1 legislation if not for what might concern the postponement of its adoption date. By asking the Commission to redraft the RTS, EFAMA hopes that the outcome is level 2 legislation enabling manufacturers to give investors basic facts on what a potential investment they make could bring them in terms of risks and costs, as this approach will contribute to restore trust and confidence amongst the investors.  

Concerns about the final draft of the RTS and how the RTSs have been rejected
In the course of discussions surrounding final stages of implementation of PRIIPs legislation, in furtherance of the release of the final draft of the level 2 legislation, a group of members of the European parliament have invoked – allegedly for the first time in the context of financial services legislation – the power to challenge the approval process of an unsatisfactory piece of legislation.

As some of you may already know, a process called Lamfalussy is normally employed when adopting legislation on financial matters. As part of this approach, there is a four-level legislative procedure adopted by the European Union for the development of relevant legislation. In the particular case of PRIIPs, whilst there seems to be unanimous consent on the principles – as contained in the level 1 legislation (Regulation 1286/2104) – expressed at various levels in the industry, there has been heavy criticism expressed in regards to the level 2 legislation proposed by the European Commission, beginning since its release and which has now culminated in the current state of affairs.

The motion presented by ECON – a Committee on Economic and Monetary affairs of the European Parliament in charge of the Economic and Monetary Union, as well as the regulation of financial services – was aimed at challenging the approval of such level 2 legislation, deemed inconsistent with the scope of protection of retail investors, which is the underlying goal of the entire PRIIPs legislation. The opposition to the level 2 regulation was based on the tenet that the current makeup of KID for PRIIPs could cause serious misleading effects in relation to retail investors. The European Parliament have adopted the said motion with a majority.

The bone of contention behind the motion to have the RTS rejected, as it was to be expected,lies with the KID. Whilst some of its requirements, for instance the way costs are to be calculated, already raised some strong criticism elsewhere, it seems that this time one other element has caused concern for the members of the European Parliament approaching the ECON for rejection of the RTS. MEPs have in this instance censored the requirement to describe future performance scenarios for the investments as potentially misleading, as this hinders the ability of investors to understand that they might also incur the risk of losses on their investment. What could be considered a landmark departure from the way the performance of financial instruments was conceived to be illustrated so far, is now under the spotlight as it may mislead investors and alter their perception of the possible financial losses that an investment in financial products may entail. More specifically, the proposed future performance scenarios communicate a worst case scenario that is based on historical time series data, and does not take account of potential overall market crashes or additional factors.
Does this mean that PRIIPs legislation will be delayed?
Now the European Parliament has voted to reject PRIIPS level 2 legislation and sent back the RTS to the Commission for a revised version. It is interesting to read in the contents of the motion for a resolution presented to the European Parliament by ECON that there is a call on the Commission to consider a proposal to postpone the application date of PRIIPs level 1 legislation. A postponement, in the eyes of the supporters of the motion, would allow for a smooth implementation of all the principles of the PRIIPs and avoid that PRIIPs level 1 legislation enters into force without RTS. However, this does not necessarily mean that a delay in the adoption of PRIIPs legislation is the only possible outcome in the event that the level 2 legislation is sent back to the Commission for revision.

In fact, it seems that the view of the Commission, as expressed by one of its very members in the course of the debate leading to the motion to ECON  is that, notwithstanding the fact that in an ideal case scenario both level 1 and level 2 legislation be introduced at the same time, it could be a second best scenario to have only level 1 legislation introduced by the same deadline. Should this approach be adopted – and there shouldn’t be any particular obstacles thereto in principle, given that the level 1 legislation was approved already – we could very well end up in a situation where the European Supervisory Authorities could release only some sort of guidance to the implementation of the PRIIPs. Whilst such guidance may not have attached any legal binding power thereto, it could be used for what is called a comply or explain approach.

In this scenario, member states will be left with the same implementation deadline of December 2016 and would adopt PRIIPs into their national legislation as they deem suitable, leading to further uncertainty and related issues in the market.

It is noteworthy to consider that there were already in the recent past some attempts made in Belgium, for instance, to front-run PRIIPs legislation. In fact, for those who remember, back in 2014 there was already a Royal Decree in Belgium – the so called Transversal Decree – which was aimed at introducing new disclosures very similar to the ones envisaged by PRIIPs legislation, when offering all sorts of financial products to retail investors. In 2015, in light of the similarities with the PRIIPs legislation and in order to ensure the most accurate alignment possible of the internal legislation with the one at European level, it was proposed to postpone the introduction of such decree until PRIIPs was completed.

The fast-paced approach of the Commission and the conviction that PRIIPS legislation would be introduced by 31 December this year counted lot, regardless of the issues and the costs that it would have added for market participants. While the majority of product developers are on time with their preparations, they are currently still waiting for appropriate guidance from European institutions, whenever that appears. The majority of manufacturers are already looking at production and are mostly on time, though they lack appropriate guidance, at least until such guidance from European institutions is likely to be expected.