Disclosure Issues Estimated Value Disclosures Indices Variable Price Reofferings

Transcription

1 2013 Morrison & Foerster LLP All Rights Reserved mofo.com Disclosure Issues Estimated Value Disclosures Indices Variable Price Reofferings December 10, 2013

2 Estimated Value Disclosures This is MoFo. 2

3 How Did We Get Here? There is a long history of related disclosures in the structured products market: Absent any changes in market conditions, resale price likely to be less than the price paid by investors. Secondary market prices likely to be affected by a variety of factors. Offering participants likely to obtain profits through underwriting discount and hedging activities. Each issuer/underwriter had its own preferred formulation. Frequent criticisms of structured products in the mainstream press often centered around these issues. Anyone can look at these types of disclosures, and ask, please quantify for me what you mean. However: is this quantification meaningful or helpful, particularly in the context of an instrument marketed as a buy and hold investment? This is MoFo. 3

4 SEC Sweep Letter April 2012 In April 2012, the SEC Division of Corporate Finance s Office of Capital Market Trends sent a letter to certain major issuers of structured notes. The form of letter is available on the SEC website, and its guidance is intended for all issuers, whether or not they received the letter. ( The letter related primarily to disclosure issues in registered structured note offering documents. This is MoFo. 4

5 Sweep Letter Questions Relating to Estimated Value Requests disclosure of the difference in the issuer s estimated value of the note from the original issue price and the actual market price. Requests additional disclosure relating to the use of proceeds of an offering. More information about liquidity in offering documents circumstances in which the issuer or its affiliates will repurchase notes from purchasers, and discussion of how the potential prices paid by the issuer for repurchases may vary over time. Reflects the SEC s view that this information is required, or at least appropriate to disclose, under provisions of Regulation S-K. This is MoFo. 5

6 Sweep Letter Follow-Up 10 months of phone calls, written submissions and in-person meetings between recipients of the letter and the SEC staff. Aborted effort by SIFMA to coordinate an industry-wide response. Did not gain much traction. SEC was mainly interested in continuing its issuer-specific discussions. SEC correspondence (now available on Edgar) tells the story the five stages of grief. Denial, Anger, Bargaining, Depression and Acceptance Initial round of issuer responses attempted to explain reasons why the disclosure wasn t required or helpful. However, by the end of the process, issuers were providing their planned language to the SEC staff. This is MoFo. 6

7 SEC Follow-Up Disclosure Letter 2013 Pricing and Valuation of Structured Notes Price value of each component Investors need to understand the difference between initial price and issuer s valuation This is MoFo. 7

8 SEC Disclosure Letter 2013 (cont d) Original Issue Price - Issuer Valuation Issuer Valuation based on (a) bond and (b) derivative Difference disclose range (in preliminary) and single number (in final) on cover page Don t include: Hedging costs (one exception) Underwriting discounts or commissions Other transaction costs This is MoFo. 8

9 SEC Disclosure Letter 2013 (cont d) Issuer Valuation Quantitative number Qualitative use of internal pricing models Model inputs and assumptions Bond value: may be based on (a) an internal funding rate or (b) an interest rate that reflects secondary market spreads. Exchange traded derivative prices and adjustments. Valuation of derivatives that don t necessarily have an observable market price. Risks with valuation methodology Example: use of internal funding rate as compared to secondary market spreads. What is the impact on the value of the notes? This is MoFo. 9

10 SEC Disclosure Letter 2013 (cont d) Issuers may use an unaffiliated third party s bid for valuing the embedded derivative, which would probably include hedging costs, if: The issuer bids out the pricing of the embedded derivative to an unaffiliated third party as the sole method of valuing the embedded derivative. The issuer does not use any internal pricing model to value the embedded derivative for any reason. The issuer discloses that it will engage in the derivative transaction with such unaffiliated third party. The disclosure would indicate that the issuer s valuation includes the unaffiliated third party s estimated hedging costs as part of its bid price for the embedded derivative. This option not readily available to issuers due to the narrow conditions that apply. This is MoFo. 10

11 SEC Disclosure Letter 2013 (cont d) Other Costs or Amounts Qualitative explain fees, costs or other amounts added to issuer s valuation This is MoFo. 11

12 SEC Disclosure Letter 2013 (cont d) Secondary Market Secondary market price > issuer s valuation Excess difference? Issuer reimbursement of amounts by which the initial offering price exceeds the estimated value Declines on [straight line basis] over [period of time] Discretionary? Amortize This is MoFo. 12

13 A Few Practical Challenges Investor education: what does this mean, and what does this not mean? Consistency in modeling, while accounting for differences across product types, desks and distribution channels. Differences can include: hedging cost and profit, commissions paid, length of amortization period. Valuing derivatives in the absence of an observable market price. Developing an appropriate pre-pricing range of estimated values. Risk of value falling below the range on the pricing date. Impact on non-registered structured products: bank notes and certificates of deposit. This is MoFo. 13

14 A Few Next Steps Issuers who have not rolled out new language may receive a letter from the Staff. SEC Staff will be reviewing and "spot checking new language. The regular reviewers assigned to issuers that didn't receive the letter will be following up with them to ensure that they incorporate estimated value disclosures in their filings. The question can arise in the context of SEC review of a registration statement. This analysis is not expected to spread to other products, particularly where there is no embedded derivative. (Example: simple LIBOR floating rate note.) This is MoFo. 14

15 Market Impact Generally constructive dialogue between SEC and industry SEC now has a better understanding of the products, and how they are manufactured and sold Issuers have opportunity to enhance existing disclosures Challenges No one size fits all issuers may have different disclosures based on distribution channel, type of product and other factors Open architecture - takes effort and careful thought Battle of the Forms reconciling the need for consistency with different institutional preferences. Impact on international regulators? Other U.S. markets or products? IOSCO s April 2013 tool kit identified estimated value disclosure as a potential regulatory option. Starting in May 2014, most German banks will disclose their estimated value for structured products, pursuant to a voluntarily adopted code of conduct. This is MoFo. 15

16 Some Obiter Dictum from the SEC (and Its Implications) The following bullets are paraphrases, and not actual quotes. We are primarily concerned about products in which the pricing is not readily understandable to retail investors. Impact on lightly-structured rate linked notes, such as fixed-to-floaters. We think that this disclosure is material and required, whether the purchasers are retail investors or institutional investors. Reverse inquiry transactions to QIBs? This is MoFo. 16

17 Proprietary Indices This is MoFo. 17

18 Overview Structured products are often linked to proprietary or novel indices. Proprietary indices may raise issues under the Securities Act of 1933, the Investment Company Act of 1940 and the Investment Advisers Act of 1940 General issues to consider Is the index created by the issuer or an affiliate ( proprietary ) or by a third party? Will there be adequate disclosure about the index and its methodology? How does the index compare against a benchmark such as the NYSE listing rules? This is MoFo. 18

19 Disclosure Issues The index methodology should be publicly available (but not incorporated by reference into the offering document) A link to the methodology may be helpful A detailed methodology is essential if the index were to be transferred to another sponsor; the methodology will ensure continuity Opaque methodologies with formulae: Translate into plain English How to summarize risk of error Include complex formulae in the offering document? Roles: index sponsor, calculation agent, information dissemination Disclose any conflicts of interest Are there similar indices to compare against, with appropriate disclosure as to the differences? Quarterly high and low closing levels of the index and the daily closing level should be publicly available free of charge at the close of business on each trading day This is MoFo. 19

20 Disclosure Issues Equity Indices General equity index information, summarized from the methodology: Method of calculation Name of calculation agent A list of the top ten constituents and all constituents representing 5% or more of the weighting of the index, and their respective weightings and, if available, a link to a list of all of the constituents How the constituents were chosen, and how new constituents are selected? Index changes and reweightings/rebalancings: when and how? How the index accounts for corporate events (mergers, etc.) and how it factors in market disruption events? If the index contains constituents from multiple industries or sectors and constituents have been classified accordingly by the index sponsor, what are the industry or sector weightings? Similarly, any country weightings? This is MoFo. 20

21 Disclosure Issues Commodities Indices General commodities index information (indices of physical commodities or commodities futures), summarized from the methodology: Describe constituents physical commodities, commodities futures or options to purchase commodities, and the markets on which they trade List the top ten constituents, and all constituents representing 5% or more of the weighting of the index, and their respective weightings and, if available, a link to a list of all of the constituents Describe the method by which the constituents were chosen or obtained Describe when and under what circumstances the constituents may be changed, reweighted, substituted or traded, as applicable Describe any rolling periods Summarize any fees or expenses charged or incurred by the index sponsor This is MoFo. 21

22 Regulatory Hot Buttons FINRA - suitability, new products, leverage, complexity Suitability - Rule The broker-dealer must understand not only the product, but the index Complicated indices are hard to explain and products linked to them should not be sold to unsophisticated investors Can a "reasonable basis" suitability determination be made for the structured product? New products Are the economics of the product suitable for at least some investors? A structured product linked to a new proprietary index may require "new product" review. Structured products linked to indices that are hard to describe may raise issues with FINRA if sold to retail investors. This is MoFo. 22

23 Regulatory Hot Buttons (cont d) FINRA - suitability, new products, leverage, complexity FINRA has warned against selling leveraged complex products to retail investors FINRA has not spoken about leverage built into an index, but they may take a dim view of a "less complex" product linked to a proprietary index with built in leverage Negative comments about volatility indices (VIX) Negative comments about leveraged ETFs and ETNs, particularly those with negative leverage This is MoFo. 23

24 Enhanced Risk Factors Disclosure Lack of operating history Backtested historicals, with appropriate explanation o What method was used to calculate the backtested data? o Were there any variations from applying the methodology to past historical data? o If there were any variations, they should be disclosed This is MoFo. 24

25 Enhanced Risk Factors Disclosure (cont d) o Clear separation between historical performance data and backtested data o Explain that the creation of backtested data necessarily involves certain assumptions o The backtested data should cover a variety of economic periods, including stressed periods o No cherry-picking choosing past periods in which the index would have performed well This is MoFo. 25

26 Enhanced Risk Factors Disclosure (cont d) o o o Backtested data should not be used to predict future performance Backtested data should be objective and capable of reproduction This excludes presenting backtested data for indices that are managed ; i.e., discretion is used in calculating the index Appropriate disclosure if comparing against similar indices Inexperienced sponsors This is MoFo. 26

27 Enhanced Risk Factors Disclosure (cont d) Is the index creator a recognized index sponsor (such as S&P, Russell or MSCI) or was the index created by an affiliate of the issuer? Complicated indices may not perform as designed Concern that an issuer could tweak a proprietary index in its favor; the concern is greater if the methodology is not publicly available This is MoFo. 27

28 FINRA, Conflicts of Interest and Proprietary Indices In October 2013, FINRA issued its Report on Conflicts of Interest, in which FINRA raised concerns about disclosure to customers about conflicts of interest relating to proprietary indices, among other items. These issues were discussed in the context of new product approval, registered representative training and product disclosures. An affiliated index calculation agent may have discretion in how it calculates the value of an index, including, potentially, the ability to change the methodology; Complexity; High or hidden costs; The possibility that they involve sophisticated or complicated trading algorithms or investment strategies, which may subject investors to fee structures that can be conditional or path dependent, require detailed analysis to understand and estimate, and/or be very costly under certain conditions; and Limited histories in which to evaluate their behavior in different market environments. Takeaway for offering documents: make sure that the risk factors fully explain these risks. This is MoFo. 28

29 Variable Price Reofferings This is MoFo. 29

30 Disclosure Issues When notes are to be sold at varying prices, the offering document can disclose: The bottom of the range of resale prices The maximum underwriting discount Risk factor disclosure: Investors may pay a price higher than that paid by other investors This is MoFo. 30

31 SEC Filing Timing for Variable Price Reoffer Prospectuses Questions can arise as to when to file the prospectus supplement during a variable price reoffering. When did the pricing occur? Does the first firm commitment to purchase constitute T for the purposes of the Rule 424(b) T+2 filing requirement? Helpful information from FINRA: On August 1, 2013 FINRA issued a set of FAQs on TRACE reporting. The FAQ appears to apply to variable price reofferings. FINRA stated that a TRACE report would not have to be filed until all the commitments in a variable price reoffering have been made, and the aggregate principal amount has been determined. A TRACE report does not necessarily constitute T for purposes of Rule 424 filing timing, but the FINRA FAQ is helpful. This is MoFo. 31