the Structured Products Law Review - Pinheiro Neto Advogados · The Structured Products Law Review...

Structured Products Law Review

EditorsChristopher S Schell, Yan Zhang and Derek Walters

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© 2019 Law Business Research Ltd

Structured Products Law Review

EditorsChristopher S Schell, Yan Zhang and Derek Walters

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Reproduced with permission from Law Business Research LtdThis article was first published in December 2019 For further information please contact [email protected]


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PREFACE ........................................................................................................................................................... vChristopher S Schell, Yan Zhang and Derek Walters

Chapter 1 BRAZIL ..................................................................................................................................1

Tiago A D Themudo Lessa, Rafael José Lopes Gaspar and Fábio Moretti de Góis

Chapter 2 CHILE ..................................................................................................................................12

José Luis Ambrosy

Chapter 3 FINLAND............................................................................................................................23

Mika J Lehtimäki

Chapter 4 JAPAN ..................................................................................................................................32

Naoya Ariyoshi, Toshiyuki Yamamoto and Yuki Taguchi

Chapter 5 SWITZERLAND ................................................................................................................41

Dominique Lecocq and Lucile Cesareo-Hostettler

Chapter 6 UNITED STATES ..............................................................................................................53

Christopher S Schell, Yan Zhang and Derek Walters

Appendix 1 ABOUT THE AUTHORS .................................................................................................77

Appendix 2 CONTRIBUTORS’ CONTACT DETAILS ....................................................................83

CONTENTS


v

PREFACE

It is our pleasure to act as the editors for this first edition of The Structured Products Law Review. Despite the significant growth of the global structured product market in recent years, very few books on legal and regulatory issues related to structured products are available. We hope that this publication will contribute to the knowledge base of legal practitioners and other structured product market participants.

For our purposes, the term structured product refers to a pre-packaged investment that combines derivatives with other financial instruments to provide a return based on the performance of one or more underlying assets, including equity securities, indices, commodities, interest rates, currencies and, in some jurisdictions, credit risks. Typical structured products are issued as debt securities, certificates of deposit or investment certificates or units, and include embedded derivatives to provide a customised risk-return trade off. Common issuers of structured products are financial institutions, other corporate issuers, special purpose vehicles and trusts. Structured products should not be confused with other structured finance products, which include asset-backed securities such as collateralised debt obligations and mortgage-backed securities, synthetic loans and credit derivatives such as credit default swaps.

Structured products have been in the spotlight since the global financial crisis in 2008. In the years following the financial crisis, there was an increase in regulatory investigations into the issuance and distribution of structured products and the promulgation of new rules and regulations to govern the conduct of structured product issuers and distributors. Regulators are particularly concerned about certain risk characteristics of structured products, including credit risk, investor suitability, pricing transparency, secondary market liquidity and conflicts of interest. Global regulators have taken a range of approaches to address these issues. To enhance investor protection, the International Organization of Securities Commissions published a report on the regulation of structured products in December 2013, which provides a toolkit outlining possible regulatory options that regulators in different jurisdictions may find useful to address their concerns about structured products. The process that led to the publication of this report has helped increase regulatory consistency across different jurisdictions and is an excellent example of international collaboration. The growing popularity of complex structured products among retail investors has also caught regulators’ attention. Pursuant to the EU Markets in Financial Instruments Directive legislation that came into effect in January 2018, an issuer is required to supplement offering materials with a key information document when offering structured products to retail investors in EU Member States in order to strengthen investor protection and improve their investment decision and selection process. Other jurisdictions have also implemented rules aimed at protecting retail investors.


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Given its unique ability to tailor investments to investor preferences, the structured product industry continues to grow at an impressive pace, and it is estimated that the size of outstanding structured products around the world has increased to over US$3 trillion in 2019. Technology plays an increasingly important role as the structured product market continues to grow in terms of issuance volume, innovation and broadening distribution channels. Recent examples include the growing popularity of online distribution platforms that provide an open marketplace for structured product issuers and distributors with a focus on streamlining the offering process to increase efficiency and transparency, the development of blockchain technology to facilitate securities clearing and settlement, and the use of large volumes of data from non-traditional sources, such as social media, to assess investors’ financial needs and to design investment strategies. In recent years, not only have market participants embraced the rise of Fintech by integrating new technology into offerings and issuances of structured products, securities regulators are also exploring the possibility of adopting new technology in structured product regulation. In Japan, online-based procedures have been permitted since November 2018 as a new know your customer (KYC) process to complement traditional face-to-face or mail-based KYC procedures. The US Securities and Exchange Commission (SEC) also has explored the use of big data in enforcement actions. In one recent example, the SEC used for the first time a coding technique against a broker-dealer that allows regulators to analyse data across an entire trading platform to identify potential unsuitable sales to a particular class of investors. The financial industry has historically been an early adopter of new technologies. There is no doubt that technological development will continue to have a profound impact on structured product markets across all jurisdictions.

The Structured Products Law Review is designed to provide an overview of recent changes and developments in legal and regulatory issues regarding structured product markets. It would not have come together without the participation of a group of top lawyers and law firms from six jurisdictions around the world. We hope that you find this book a useful tool in navigating the ever-changing legal and regulatory landscape in a fast-growing industry.

Finally, we would like to thank our counsel, Vidal Vanhoof, and other colleagues for their contributions in editing this book and the team at Law Business Research for their patience and efforts in compiling this edition.

Christopher S Schell, Yan Zhang and Derek WaltersDavis Polk & Wardwell LLPNew YorkNovember 2019


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Chapter 1

BRAZIL

Tiago A D Themudo Lessa, Rafael José Lopes Gaspar and Fábio Moretti de Góis1

I OVERVIEW

This chapter describes certain legal and regulatory aspects related to certificates of structured transactions (COEs).

COEs, as provided under Brazilian law, are certificates issued against an initial investment and represent a single and indivisible set of rights and obligations, with the structure of yields referencing characteristics of financial derivatives instruments. In other words, COEs are bonds that may be issued by financial institutions and that can be referenced to a wide range of underlying assets such as, among other things, indexes, currencies and stock prices. Such characteristics make the COE a unique instrument that has been widely adopted by market participants in recent years. Based on public information provided by B3 SA – Brasil, Bolsa, Balcão (B3),2 currently approximately 19 billion reais’ worth of COEs have been issued in Brazil.

II LEGAL AND REGULATORY FRAMEWORK

COEs were created by Law No. 12,249, of 11 June 2010, as amended (Law 12,249) and regulated by Resolution No. 4,263, of 5 September 2013, as amended (Resolution 4,263), and was enacted by the National Monetary Council (CMN).

Law 12,249 gives financial institutions the general authority to issue COEs, granting the CMN powers to provide additional conditions for such issuance. Such conditions are specified in Resolution 4,263 and enacted by the CMN, which provides general guidelines related to COEs, including on assets underlying COEs. In this respect, Articles 6 and 7 of Resolution 4,263 set forth what would qualify as an underlying asset for purposes of a COE as follows:a the COE can be referenced to price indexes, bond indexes, securities indexes, interest

rates, exchange rates, securities and other underlying assets, provided that at least:• the price index, bond index, securities index, interest rate or exchange rate used as

a reference shall be calculated on a regular basis and subject to public disclosure; and

• the securities and other underlying assets used as a reference shall present quotations that are regularly published by stock exchanges, commodities and

1 Tiago A D Themudo Lessa is a partner and Rafael José Lopes Gaspar and Fábio Moretti de Góis are associates at Pinheiro Neto Advogados.

2 http://www.b3.com.br/pt_br/market-data-e-indices/servicos-de-dados/market-data/historico/renda-fixa/.


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futures exchanges, organised over-the-counter markets or clearings duly authorised to operate by the Central Bank of Brazil and the Brazilian Securities Commission;

b the use of underlying assets determined by a methodology that combines references outlined above is permissible, provided that it is consistent and verifiable;

c the use of the methodology mentioned in (b) is the exclusive responsibility of the issuing institution;

d the values and quotations of the underlying assets shall be independent from the parameters used for the proprietary transactions of the issuing institutions;3 and

e the COE can be referenced to underlying assets made available or traded offshore provided that the requirements set out above are duly observed, including those with respect to exchanges and over-the-counter markets, which shall be regulated by the competent foreign authorities.

Resolution 4,263 also provides for two important requirements related to a COE issuance. The first is set forth in Article 11 and relates to the suitability proceedings (for further information on suitability proceedings under Brazilian regulation, refer to Section III.iii) that shall be carried out by the issuer of the COE and, if applicable, by the intermediary institution that distributes the COE to other investors (intermediary institution). The second is set forth in Article 12 and relates to the information provided by the issuer of the COE and the intermediary institution to the COE’s investors.

The requirements of Articles 11 and 12 of Resolution 4,263 are as follows:a an issuer and institution that participate in a COE’s distribution, placement and

negotiation proceedings must implement policies and proceedings that ensure the COE’s suitability to the profile of the investors, and observe investors’ needs, interests and objectives; and

b an issuer and institution that participate in a COE’s distribution, placement and negotiation proceedings must ensure that the information related to the COE is rendered through documents made available to investors that must be worded in a manner that is clear, objective and adequate to its nature and complexity, in order to allow the full comprehension regarding the conditions, payments flows and risks related to the COE.

As to the requirements mentioned above, the Brazilian Association of the Entities of the Financial and Capital Markets (ANBIMA) enacted Deliberation No. 22 on 12 June 2017 (Deliberation 22 and, together with Resolution 4,263 and Instruction No. 569, of 14 October 2015 of the Brazilian Securities Commission (CVM), as amended (Instruction CVM 569), the COE Regulations).4 ANBIMA is a self-regulatory entity of the Brazilian financial and capital markets. Deliberation 22 provides for the obligations and liabilities attributable to public offerings of COEs carried out by their members.

3 The purpose of this is to avoid potential conflicts of interest and to ensure that the issuer of the COE is not able to affect the results of the COE, whether positive or negatively.

4 It is important to mention that in Brazil, laws and regulations are interpreted according to their hierarchy. In this sense, Law 12,249 ranks hierarchically higher than Resolution 4,263, Instruction CVM 569 and Deliberation 22. From a practical standpoint, considering that Resolution 4,263 and Instruction CVM 569 are administrative regulations, both should have the same hierarchy rank. Notwithstanding,


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Article 6 of Deliberation 22 sets forth, among a series of conditions, that an intermediary institution that distributes a COE must ensure that the information related to the COE is provided prior to the acquisition of the COE by its investors by means of the delivery of a COE document. The COE document is defined in Article 4 of Deliberation 22, and such definition coincides with that of the essential information document (DIE).

In addition to the above, Article 4 sets forth that if a distribution of a COE is carried out by an intermediary institution, the issuer of the COE shall be responsible for the preparation of the COE document, while the intermediary institution shall be exclusively liable for the suitability proceedings (see Section III.iii). Thus, differing from Articles 11 and 12 of Resolution 4,263, Deliberation 22 provides for a segregation of the duties of the issuer of the COE and of its intermediary institution.

III OFFERING PROCESS AND POST-SALE REQUIREMENTS

The offering of a COE to the public is regulated by Instruction CVM 569, as enacted by the CVM. Instruction CVM 569 provides the rules that must be observed for the purposes of offering COEs to the public. In this sense, Instruction CVM 569 clearly sets forth the issuer and intermediary institution obligations related to the preparation of documents related to a COE offering, as well as its applicable marketing materials (as defined below).

As such, according to Article 3 of Instruction CVM 569, the intermediary institution, or the issuer of a COE acting as the intermediary institution, shall deliver a DIE to investors before the acquisition of a COE, and maintain a term of adhesion and risk acknowledgement (adhesion term) signed by the investor with the following wording: ‘I have received a version of the essential information document previously to the acquisition of the COE and have acknowledged how it works and its risks.’5

In addition, Article 3, Paragraph 2 of Instruction CVM 569 sets forth that the obligations mentioned in Article 3 of Instruction CVM 569 shall be waived if an investor in a COE is a professional investor.

In this sense, below is the definition of professional investor as provided by CVM Instruction No. 539, of 13 November 2013, as amended (Instruction CVM 539). According to Article 9-A, professional investors are:a financial institutions and other institutions authorised to act by the Central Bank of

Brazil;b insurance companies and capitalisation companies;c open and closed supplementary pension entities;d individuals and legal entities that have financial investments in an amount higher

than 10 million reais, and that additionally represent in writing their condition as professional investors, in accordance with Annex 9-A;

e investment funds;f investment clubs, provided they have a portfolio managed by a portfolio manager duly

authorised by the CVM;

from a theoretical perspective, the CVM is subject to the CMN; thus, one could conclude that Resolution 4,263 should rank higher than Instruction CVM 569. Finally, Deliberation 22 was issued by ANBIMA, and thus ranks inferior to Law 12,249, Resolution 4,263 and Instruction CVM 569 in the legal hierarchy.

5 It is important to mention that Article 3, Paragraph 1 of Instruction CVM 569 sets forth the provisions of the DIE to the investor, and the execution of the adhesion term can be done electronically.


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g independent investment agents, portfolio managers, securities analysts and securities advisers duly authorised by the CVM in relation to their own resources; and

h non-resident investors.

i Information provided by the DIE

The main document related to a COE issuance is the DIE. The following is an analysis of the main conditions that shall be included in each DIE.

Articles 6 and 7 of Instruction CVM 569 set forth the main requirements that need to be included in the DIE as follows:a according to Article 6, the DIE must:

• contain true, complete and consistent information that does not mislead investors;

• be written in simple, clear, objective, concise and adequate language that respects the nature and complexity of the COE; and

• be useful for an evaluation of whether to invest in the COE; andb according to Article 7, the DIE must present the following items:

• the issuer’s name and CNPJ number;6

• a warning that receipt of the amounts due to investors is subject to the risk of the credit of the issuer of the certificate;

• a description of the COE’s nature and essential characteristics, highlighting whether the COE is of a ‘protected initial investment amount’ or ‘initial investment amount under risk’ modality, as well as details of the peculiarities inherent in the respective modalities, especially with respect to the possibility of the loss of invested capital;

• the minimum initial investment or nominal value, if any;• when periodic payments of interest will be available;• the due date or term of the transaction;• the value of the protected investment, with a notice regarding the need for

immobilisation of the investment for a certain period, if this is the case;• the underlying assets that have been used as benchmarks, and information about

how to obtain the value of the indexes, rates or quotations;• a warning that it is not a direct investment in the underlying asset;• complete data on all performance scenarios related to the COE based on

fluctuations of the underlying assets, including a notice that such results are valid at maturity;

• a specification of the rights and covenants of the holder and the issuer, respectively, that may influence remuneration conditions;

• conditions for the repurchase or redemption of the COE before the maturity date;

• a warning about the physical delivery conditions of the underlying asset, when applicable;

• a warning regarding the conditions that might entail the extinction of the COE before maturity;

6 The CNJP is a register all entities are required to be entered in prior to commencing their activities.


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• a warning regarding the liquidity conditions of the investment, including information on the admission to trading of the COE in the secondary market and regarding market makers, if any;

• an indication and brief description of the main risk factors;• a warning that the COE is not guaranteed by the Credit Guarantee Fund;• an indication of the entities that maintain systems in which the COE will be

issued;• a warning using the following wording: ‘This offer was waived from registration

by the Brazilian Securities Commission – CVM. The distribution of the COE does not imply, by the regulatory entities, a guarantee of the veracity of the information provided or the adequacy of the COE to the current legislation or a judgment on the quality of the issuer or the intermediary institution’;

• information on any other factor that could significantly affect the conditions of the transaction;

• a description of the applicable taxation; and• guidance on how to file a complaint or clarify questions regarding the COE.

In addition, the formatting, structure and layout of the information in the DIE must not diminish the relevance of any of the items in the caput.

It is important to mention that Articles 11 and 12 of Instruction CVM 569 set forth some items that need to be included in specific scenarios, but that are not mandatory, as follows:a according to Article 11, a reference to profitability, including in a DIE, must always

include the effective rate expressed as a percentage per year, and it must be displayed with equal prominence; and

b according to Article 12, any information disclosed by any means, including in the DIE, in which a reference to the past profitability of the COE is included must:• present a chart with figures obtained on a daily basis showing the evolution of the

COE’s performance against certificates that are identical to the COE, and that have matured over a period identical to that of the COE’s;

• when reference is made to the evolution of the price of the underlying assets of the COE, include a warning with the following wording: ‘These values are simply illustrative and do not represent the past performance of the COE’;

• include a warning with the following wording: ‘Reference to past profitability is not a guarantee of future profitability’;

• include clear identification of the reference period of the past profitability, including the initial and final dates; and

• mention that the net profitability depends on the applicable taxes.

A reasonable doubt that usually arises is whether information related to an underlying asset of a COE could be cross-referenced in the DIE. In this sense, it is important to mention that the DIE must necessarily contain the information requested under Article 7 of Instruction CVM 569, including Item VIII of Article 7. The original wording of Item VIII provided that the DIE should present ‘the underlying assets used as benchmarks’, but the CVM, upon receipt of comments from market participants during the public hearing process for


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Instruction CVM 569, revised the original wording to provide that the DIE should contain ‘the underlying assets used as benchmarks and information on how to obtain the values of the indexes, rates or quotations’.

Thus, based on the above, the DIE should observe Article 7, Item VIII of Instruction CVM 569, and indicate which is the underlying asset related to the COE and how further information about such underlying asset can be obtained (e.g., quotations, values, calculation methodology). The insertion of a cross reference to information related to the underlying asset in the DIE should suffice for the purposes of this requirement. In any case, the key aspect is that the information provided in the DIE should allow investors to understand, inter alia, the security, index and rates used as underlying assets with the purpose of providing such investor with assistance and clarity on her or his investment decision.

From a practical standpoint, any further information about the underlying asset could be included in the DIE, or the DIE could provide for a web link, a specific website or guidance on how to access a website pursuant to which the investor would have access to such further information.

ii Marketing materials

Producing marketing materials to sell COEs is allowed under the Brazilian regulations. Article 8 of Instruction CVM 569 sets forth that any advertising text or audiovisual material for offering, announcing or promoting the issuance of COEs (marketing materials) shall:a follow the general rules of disclosure of information set forth in Article 6 of Instruction

CVM 569, which provides for the requirements attributable to the DIE;b be consistent and not contain different information related to the content of the DIE;c use calm and moderate language, and contain a warning related to any investment

risks, including that receipt of the amounts owed to the investor is subject to the credit risk of the issuer of the COE;

d mention that it is marketing material;e alert the investor about the existence of the DIE and the means to obtain a copy, as well

as provide the following wording: ‘Read the DIE before investing in this COE’;f highlight that the certificate is for an investment with nominal value at risk modality

when this is the case; andg include a warning with the following wording: ‘This offer has been waived from

registration by the CVM. The distribution of the COE does not imply, on the part of the regulatory entities, a guarantee of the veracity of the information provided or the adequacy of the COE to the current legislation or judgment on the quality of the issuer or the intermediary institution.’

In other words, any marketing material related to issuances of COEs must observe Article 8, among other provisions set forth in Instruction CVM 569, in addition to the requirements set out by Article 12 of Resolution 4,263.

For the sake of clarity, the definition of marketing materials shall include any audiovisual material that may be embedded in marketing materials in text format, particularly in the event such audiovisual material presents language identifying that it shall be considered as marketing material for the purposes of the COE offering.


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iii Suitability proceedings

Another important aspect of COE issuances is how the Brazilian regulations deal with the level of diligence in suitability proceedings that shall be carried out by an intermediary institution, as applicable.

In this sense, Instruction CVM 539 provides for suitability proceedings7 that shall be carried out by intermediary institutions with potential investors in order to recommend products (e.g., COEs) or transactions, or to provide services to such potential investors.

Article 2 of Instruction CVM 539 sets forth that an intermediary institution must verify:a whether the product, service or transaction is suitable to the investment objectives of

the client;b whether the financial status of the client is compatible with the product, service or

transaction; andc whether the client has the knowledge required to comprehend the risks related to a

product, service or transaction.

Furthermore, Article 2, Paragraphs 1, 2 and 3 of Instruction CVM 539 provide for the information or documents, or both, that shall be presented to a potential investor under the suitability proceeding, as set forth below:a to comply with the provisions of Item I of Article 2, the persons referred to in Article 1 of

Instruction CVM 539 (i.e., intermediary institutions and securities consultants) shall examine at least:• the period for which the client wishes to maintain his or her investment;• the client’s preferences regarding risk taking; and• the purposes of the investment;

b to comply with the provisions of Item II of Article 2, the persons referred to in Article 1 present a chart showing the evolution of the COE’s performance, obtained on a daily basis, of certificates identical to the COE and that have matured in a period identical to the COE shall examine at least: • the value of the regular revenue declared by the client;• the value of the assets that compose the net worth of the client; and• the future need for resources declared by the client; and

c to comply with the provisions of Item III of Article 2, the persons referred to in Article 1 of Instruction CVM 539 shall examine at least:• the types of products, services and transactions that the client is familiar with;• the nature, volume and frequency of transactions already carried out by the client

in the securities market, as well as the period during which such transactions were carried out; and

• the academic background and professional experience of the client.

With respect to Article 2, Paragraph 2, it is important to note that the information provided for in Items I and III may be declared by a potential investor. Notwithstanding, Item II does not expressly provide that the value and the assets that compose the net worth of a client may

7 Article 8 of Instruction CVM 539 sets forth that the institution responsible for the suitability proceeding shall update the information related to its clients’ profiles, and carry out new analysis and classification of the categories of securities, within time frames that do not exceed 24 months.


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be declared by the potential investor. In this sense, it could be concluded that Item II should be backed up by the potential investor with concrete information (e.g., an annual income declaration).

To further understand the extension of the obligation provided for by Item II, the Brazilian Association of International Banks, when providing comments on Instruction CVM 539 (during its public hearing process), mentioned that the information provided for in Article 2, Item II is usually declared by the potential investor, and asked whether language could be added to the draft Instruction to clarify that information declared by potential investors could be used for the purposes of complying with the requirement set out by Article 2, Item II. The CVM responded as follows:

Usually this shall be the practical situation. Notwithstanding, if there is evidence that may lead to the understanding that the financial situation of the client does not correspond to the reality, the persons referred to in Article 1 (i.e., the institution carrying out the suitability proceeding) cannot refrain from checking information on the client’s real financial situation.

Thus, based on the CVM’s response, an intermediary institution should be able to verify the financial status of a client and its suitability for the applicable product, service or transaction (which includes the value and the assets that compose the net worth of the client) by means of a declaration by the potential investor.

Notwithstanding, in the event that there is evidence that the declaration provided by the potential investor does not correspond to its real financial situation, the intermediary institution must request from, and verify, additional information and documentation about such potential investor in the context of its suitability process. It is important to mention that we are not aware of any formal guidance from the CVM on how discrepancies between such a declaration and the reality of an investor’s financial situation should be identified.

iv Other provisions of Instruction CVM 539

Further to the above, it is important to mention some provisions of Instruction CVM 539 that affect the suitability proceedings adopted by institutions.

In this sense, Article 5 of Instruction CVM 539 sets forth that an institution that shall carry out a suitability proceeding is prohibited from recommending products or services to a client when the profile of the client is not suitable for the product or service (i.e., the client does not have the knowledge required to comprehend the risks related to the product or service), the information that allows the identification of the customer’s profile is not obtained or the client’s profile information is not up to date.

In addition, Article 6 of Instruction CVM 539 sets forth that in cases where a client does not comply with any of the items provided for above, the institution shall, prior to the client entering into any securities transaction, notify the client about an absence of information, or the outdated status of its profile or its inadequacy, indicating the causes of the divergence; and obtain an express statement from the client acknowledging his or her knowledge about the absent, outdated or inadequate profile.


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With respect to the institution carrying out a suitability proceeding, Article 7 of Instruction CVM 539 further sets forth that such institution must:a establish written rules and procedures, as well as internal controls that can be corroborated,

that allow full compliance with the duty to verify the suitability proceedings; b adopt specific internal policies related to the recommendation of complex products

highlighting the risks of the structure of complex products compared to the structure of traditional products; and the difficulty in determining their value, including when related to their low liquidity; and

c appoint a statutory director responsible for compliance with the standards established by Instruction CVM 539.

Finally, it is important to mention that Article 10 of Instruction CVM 539 sets forth that an institution carrying out a suitability proceeding must maintain, for a minimum period of five years from the last recommendation made to the client, or from the last transaction entered into by the client, as the case may be, or for a longer period, as per the express resolution of the CVM, all documents and statements required by Instruction CVM 539. Such documents may be stored in physical or electronic media, allowing for the substitution of documents with their respective digital images.

IV EXCHANGE LISTING AND TRADING

Once COEs are offered to the public at large, they should be deemed to be securities in accordance with Article 2, Item IX of Law No. 6,385, dated 7 December 1976.

As a general rule, securities need to be deposited with centralised depositories in order to be distributed to the public at large in accordance with CVM Instruction No. 541, enacted on 20 December 2013, as amended (CVM Instruction 541). Notwithstanding, CVM Instruction 541 provides for an exception for COEs. Such exception provides that COEs that are not authorised to be negotiated in centralised and multilateral systems maintained by an organised market administrator do not need to be deposited to be distributed to the public at large.

Despite the above-mentioned rule, it is usual that COEs are deposited in accordance with CVM Instruction 541. Such deposit is usually carried out by the issuer of the COE with B3. Since this is a quite new financial product, we are not certain whether the secondary market of COEs is thriving.

V TAX CONSIDERATIONS

As a general rule, positive revenues obtained are subject to a levy of withholding income tax at regressive rates based on the period of investment, on settlement, on the revenues distributed or on the assignment of the investment, as per the table below:

Applicable rate (%) Term of the COE

22.5 Up to 180 days

20 Between 181 and 360 days

17.5 Between 361 and 720 days

15 More than 720 days


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VI PENALTIES AND SANCTIONS

According to Law No. 6,385, dated 7 December 1976, as amended, the following penalties may be imposed by the CVM upon a failure by the applicable market participants to comply with its regulations: a a warning; b a fine; c suspension from the duties of the administrator of a publicly held company, from an

entity taking part in the securities distribution system or from other bodies that require authorisation by, or registration with, the CVM;

d a temporary disqualification, for a period of up to 20 years, from occupying the position of an administrator, director or member of the audit committee of any listed company, any entity in the securities distribution system or any other entities that require approval by the CVM or the Central Bank to operate;

e suspension of an authorisation or registration for the execution of the activities regulated under the referred law;

f a temporary prohibition, for a period of up to 20 years, on the execution of the activities regulated under the referred law;

g a temporary prohibition, for a period of up to 20 years, from practising certain activities or transactions in entities that are part of the securities distribution system or other entities that depend on authorisation by, or registration with, the CVM; or

h a temporary prohibition, for a period of up to 10 years, to conduct, directly or indirectly, one or more types of transactions in the securities market.

Any fines that are applied must consider the principles of proportionality, reasonability, economic capacity and the motives that justify their imposition, and are limited to the greater of the following:a 50 million reais; b twice the value of the issuance or illegal transaction; c three times the value of the benefit received or the loss mitigated through the illegal

transaction; or d twice the damage caused to investors.

The penalties listed above may only be applied in cases of serious infractions, as determined under the applicable regulations.

COE offers that violate Articles 2, 3, 5, 9, 11 or 12 of Instruction CVM 569, and non-compliance with the requirement set forth in Article 13 of Instruction CVM 569, may be deemed serious infractions.8

8 Article 2 sets forth provisions related to the public offering of COEs. Article 3 sets forth certain obligations applicable to the intermediary institution or the issuer of a COE acting as intermediary institution. Article 5 sets forth that the issuer must draft a DIE to allow an investor to understand how the COE works. Article 9 sets forth that marketing material providing for scenarios must not highlight the best case scenario. Articles 11 and 12 set forth how information about the profitability of a COE should be in the DIE or marketing materials. Article 13 sets forth that the issuer of a COE and intermediary institutions must keep the documents and information requested by Instruction CVM 569 by five years following the maturity of the COE.


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VII OUTLOOK AND CONCLUSIONS

Overall, the COE is proving to be a well-defined product: flexibility is provided by a wide range of underlying assets, which offers an incentive for issuers to use such instrument, while clear rules create a safe environment for investors.

The rules applicable to COEs tend to be less bureaucratic and burdensome when compared to other financial assets and securities that are constantly issued in the market. The COE is a complex financial product, but even with such complexity the regulators have found a way to promote the COE market, always looking to investors, and it should be recognised that the COE is a successful financial product.

On 15 July 2019, the CVM published Public Hearing SDM No. 04/19,9 which has the main objectives of creating rules to offer financial bills and real estate secured bills, as well as updating Instruction CVM 569, to modernise the rules in order to offer COEs to the public at large. The rules related to financial bills and real estate secured bills will apparently be based on Instruction CVM 569, which demonstrates that Instruction CVM 569 was well drafted and has become quite a market standard.

9 http://www.cvm.gov.br/export/sites/cvm/audiencias_publicas/ap_sdm/anexos/2019/sdm0419_Edital.pdf.


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Chapter 2

CHILE

José Luis Ambrosy1

I OVERVIEW

The Chilean market for structured products mostly consists of products specifically designed and issued by foreign financing institutions (primarily major financial banks in the US and Europe) with the characteristic of having an embedded derivative that provides economic exposure to retail customers in Chile for reference assets, indices or other economic values, including commodities, equities, currencies, credit and interest rates. No market for structured products issued in Chile has developed.

These type of instruments are commonly designed by issuers and generally distributed by Chilean intermediaries in Chile (normally the major Chilean banks and financial institutions through their investment managers or funds administrators) for their potential clients in Chile, which include, among others, high-net-worth individuals, other intermediaries, corporations, pension funds, insurance companies, financial institutions (including banks) and asset managers (such as mutual funds and investment funds). The Chilean market for structured products also includes instruments that are manufactured by the same Chilean intermediaries in Chile to service the perceived investment needs of their clients, and are even sometimes requested and structured by experienced and sophisticated investors who are willing and able to bear the economic risks of such an investment.

Structured products can be highly illiquid and are not suitable for all investors. Therefore, for the purposes of unlocking the possibility of solutions tailored just for retail and institutional investors, and in order to extend the market to less sophisticated retail clients seeking access to certain non-traditional streams of return, or anxious to improve transparency, credit risk and liquidity, fund administration companies have structured access to foreign structured notes through the creation of investment vehicles (public or mutual funds duly registered with the Chilean Commission for the Financial Market (CMF)) that, although still very illiquid, trade in the Santiago Stock Exchange and are subject to the reporting obligations imposed by the CMF. These funds also combine the returns offered by a foreign stock market together with those of the foreign debt instruments market, guaranteeing 100 per cent of the nominal capital initially invested, a minimum gain (per cent) plus an additional return related to the variation of some stock index (i.e., S&P 500). However, although the vast majority of these funds guarantee 100 per cent of the capital invested by a client at the end of the fund’s life, it must be taken into account that it is the nominal capital (not readjusted) that is guaranteed, so great care must be taken with the inflation factor.

1 José Luis Ambrosy is a partner at Claro & Cia.


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The principal types of instruments that are marketed and sold in Chile include total return swaps (TRSs), over-the-counter options, principal protected notes, certificates (CDOs), leveraged certificates, warrants, credit linked products and hybrids (or combinations of these). Structured products in Chile are essentially sold over the counter.

For the purposes of this chapter, we do not consider any types of derivatives such as foreign currency derivatives and interest rate derivatives.


Both the marketing and sale of structured products in Chile, as well as the purchase of such instruments by Chilean investors, are subject to different legal and regulatory frameworks from the issuer or distributor point of view and the point of view of investors on the other side.

i Marketing and sale of products in Chile

Special attention should be paid to the possibility that the marketing and sale of products in Chile could be considered either a public offering of securities or brokerage of the same, which are thus subject to the provisions of the Chilean Securities Market Law;2 or the solicitation or intermediation of money, thus being subject to the provisions of the General Banking Law.3

Based on the above, the following is a general overview of the Chilean laws and regulations governing public offerings of securities, the brokerage of publicly traded securities and money intermediation.

Public offering of securities

The Securities Market Law governs, among other things, the public offering of securities. Private offerings of securities and public offerings of instruments that do not qualify as securities are, therefore, outwith the scope of the Securities Market Law.

For the purpose of determining the scope of its provisions, Article 3 of the Securities Market Law defines the term security as ‘any transferable instrument, including shares of stock, options for the purchase and sale of shares of stock, bonds, debentures, quotas of mutual funds, savings plans, commercial papers and, generally, any investment or credit instruments’.

The Securities Market Law distinguishes between private and public offerings of securities. Article 4 of the Securities Market Law provides that an offer of securities constitutes an offer to the public when addressed to the public at large or to a certain sector or specific group of the public. If the marketing efforts of the issuer or the distributor when offering the structured products are addressed to the public at large or to a certain sector or specific group of the public in Chile, they will fall within the scope of the Securities Market Law as an offer to the public and will be subject to registration requirements. Otherwise, the rules applicable to public offerings do not apply. Any other offering constitutes a private offering of securities and, therefore, is excluded from the scope of the provisions of the Securities Market Law, unless otherwise provided therein.

2 The Chilean Securities Market Law, Law No. 18,045, as amended.3 The General Banking Law, Decree with Force of Law No. 3 of 1997, as amended.


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Pursuant to Article 6 of the Securities Market Law, no public offering of securities can be made in Chile unless the securities themselves and the issuer thereof are duly registered in the Securities Registry or in the Foreign Securities Registry of the CMF.

Notwithstanding the above, the CMF is vested with the authority to determine, through a general regulation, whether a certain issuance or placement of shares or of other securities constitutes a public offering within the meaning of the Securities Market Law. Pursuant to General Regulation No. 336, the local regulator has determined the conditions that must be met for an offer of securities not to be considered a public offer (private offer exemption).

The securities being offered under a private offer exemption shall not be registered under the Securities Market Law in the Securities Registry or in the Foreign Securities Registry of the CMF and, therefore, are not subject to the supervision of the CMF. Unregistered securities in Chile are not required to disclose public information about the notes in Chile and, accordingly, such securities cannot and will not be publicly offered to persons in Chile unless they are registered in the corresponding Securities Registry. The securities may only be offered in Chile in circumstances that do not constitute a public offering under Chilean law or in compliance with CMF General Regulation No. 336. Pursuant to the Securities Market Law, a public offering of securities is an offering that is addressed to the general public or to certain specific categories or groups thereof. Considering that the definition of public offering is quite broad, even an offering addressed to a small group of investors may be considered to be addressed to a certain specific category or group of the public and therefore would be considered public under the applicable law. However, pursuant to the Securities Market Law, the securities may be privately offered in Chile to certain qualified investors identified as such therein (which in turn are further described in CMF General Regulation No. 216 dated 12 June 2008).

Furthermore, in accordance with General Regulation No. 345, the CMF exempts, under the registration requirements, the offering of securities that meet certain requirements (a General Regulation No. 345 exemption), such as the offering of: a instruments representing equity interests (capital) that represent at least 10 per cent

of the capital of the issuer; and the conditions of the offer contemplate a minimum investment by each investor of an acquisition of 2 per cent or more of the share capital of the issuer;

b local and foreign instruments representative of the capital of an entity, its subsidiaries or affiliated companies, or of its subsidiaries, where the offer is addressed to the employees of that entity, of its subsidiaries or of affiliated companies; and

c instruments representing the capital of an entity, of its subsidiaries, or of affiliated companies of that company or of its subsidiaries, whose ownership is a requirement for the use or enjoyment of the facilities or infrastructure of that entity whose business or purpose is exclusively related to charitable, educational or sporting activities, and such offer is intended to enable those who will participate in the same access to those benefits. In this case, the issuer is only required to file certain information with the CMF five business days prior to the commencement of the offer.

The restriction for public offers is imposed on the person or entity conducting the offering and not on the issuer itself (where different). However, whether third-party issuers may be held liable is something that would depend on whether the relationship between the offeror and the relevant third-party issuer can be construed as a joint effort to offer products or securities.

Special consideration shall be made regarding the fact that unless an offering of foreign securities qualifies as a private placement, such offering should comply with the provisions


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of the Securities Market Law regarding public offering of offshore securities. The Securities Market Law governs only the public offering of securities in Chile, their markets established and in operation in the country, and the Chilean stock exchanges and brokers.

Brokerage of securities

The Securities Market Law reserves the intermediation or brokerage in Chile of publicly traded securities exclusively to stockbrokers and broker dealers registered with the CMF and, in certain events, to banks and financial institutions established in Chile.

Money intermediation

Pursuant to the General Banking Law, unless specifically authorised by law, no individual or legal entity may: a engage in business reserved by law to banks and, particularly, the business of receiving

or soliciting money or other repayable funds from the public, whether as a deposit or loan, or in any other manner; or

b engage, for its own account or for the account of other persons, in the business of money brokering or in the intermediation or brokerage of credits evidenced by securities, commercial paper or any other type of debt instrument.

The public was expressly warned about the foregoing by the CMF (formerly the Superintendency of Banks and Financial Institutions) by means of a joint regulation (Circular No. 960) on 14 August 1990.

Note that the General Banking Law governs only General Banking Law activities in Chile and those banks authorised to operate in the country.

ii Eligible counterparts

On a different note, it should be borne in mind that there are certain restrictions that would prevent or limit individuals, corporations in general, banks, insurance companies, pension funds and mutual or investment funds from acquiring structured products and foreign securities in general from persons or entities not domiciled or resident in Chile. However, be advised that the Chilean regulations allow the following entities to invest in structured products as mentioned below.

Banks

Chilean banks and local branches of foreign banks shall comply with the rules set forth by Chapter XIII of the Compendium of Foreign Exchange Regulations (Compendium) and Chapter III.B.5 of the Compendium of Financial Regulations, both of the Central Bank of Chile (Central Bank), and the rules and regulations issued by the CMF.

Under current Chilean banking regulations, banks may invest in certain foreign currency securities. Banks in Chile may only invest in equity securities of foreign banks and certain other foreign companies in which Chilean banks would be able to invest if those companies were incorporated in Chile. Banks in Chile may only invest in foreign debt securities traded in formal secondary markets (as defined in the Central Bank regulations). Such debt securities shall qualify as securities issued or guaranteed by foreign sovereign states or their central banks or other foreign or international financial entities, and bonds issued by foreign companies. Such debt securities must have a minimum rating as follows:


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Table 1

Rating agency Short‑term Long‑term

Moody’s P2 Baa3

Standard & Poor’s A2 BBB-

Fitch rating service F2 BBB-

Dominion bond rating service R2 BBB (low)

In the case that a short-term security has no rating, the requirement will be deemed fulfilled if the same issuer has current long-term securities complying with the conditions set out above and provided that the referred-to short and long-term securities have similar guarantees, preferences or privileges or other legal condition having a favourable effect on the potential payment of the obligation

Table 2


Moody’s P2 Ba3

Standard & Poor’s A2 BB-

Fitch rating service F2 BB-

Dominion bond rating service R2 BB (low)

In the case that a short-term security has no rating, or is rated as P-3, A-3, F3 or R-3, the requirement will be deemed fulfilled if the same issuer has current long-term securities complying with the conditions set out above and provided that the referred-to short and long-term securities have similar guarantees, preferences or privileges or other legal condition having a favourable effect on the potential payment of the obligation

Table 3


Moody’s P1 Aa3

Standard & Poor’s A1+ AA-

Fitch rating service F1+ AA-

Dominion bond rating service R1(high) AA (low)

In the case that a short-term security has no rating, the requirement will be deemed fulfilled if the same issuer has current long-term securities complying with the conditions set out above and provided that the referred-to short and long-term securities have similar guarantees, preferences or privileges or other legal condition having a favourable effect on the potential payment of the obligation

Further, in the event that the sum of the investments of a bank in the type of foreign securities referred in Tables 1 and 2 and of all loans granted to foreign individuals and entities (other than loans granted to finance Chilean exports or imports) exceeds 70 per cent of such bank’s effective net equity, the excess is subject to a 100 per cent mandatory reserve requirement. However, banks may invest abroad in securities with a rating equal to or higher than the ones indicated in Table 3 for an additional amount equivalent to 70 per cent of such bank’s effective net equity without being subject to the aforementioned reserve requirement.

Similarly, and without prejudice to the foregoing, banks established in Chile may also make financial investments in the following instruments: a securities that do not have a risk classification issued or guaranteed by states or foreign

central banks. For these purposes, such instruments shall be assigned the international risk classification of the country in which the issuer is located; and

b structured notes issued by investment banks that have an international risk classification not lower than that indicated in Table 3, the return of which is linked to a sovereign or


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corporate fixed-income instrument, with a classification not lower than that described in Table 2. Such instruments shall be listed on formal secondary markets located in countries with an international risk rating of not less than BB- or its equivalent.

Notwithstanding the foregoing, instruments may not have a formal secondary market to the extent that appropriate accounting provisions for the corresponding country risk are established.

Banking companies that make the financial investments referred to above shall, in any case, inform the International Financial Operations Management of the Central Bank about them within the terms and in accordance with the procedures established for such purpose in Chapter XIII of the Compendium and its corresponding manuals.

Insurance companies

Pursuant to the Insurance Company Act,4 insurance companies may invest the funds of their technical reserves and risk equity in negotiable instruments issued by foreign banks and bonds issued by foreign companies, provided such instruments are rated by at least two international rating agencies. General Rule No. 152 issued by the CMF provides that Chilean insurance companies may invest the funds of their technical reserves and risk equity in deposits, bonds, promissory notes and other negotiable instruments representing debt or credit, issued by foreign financial institutions, companies and corporations. Such instruments must have a risk rating given by at least two international risk rating agencies, which must be among those selected by the CCR (the rating entity approving the securities in which pension funds may invest) when evaluating the risk of the investments to be made by Chilean pension funds. In any event, the risk rating of those instruments may never be lower than BB or its equivalent, as the case may be. In addition, these instruments shall have daily and public price statistics publicised through recognised information systems.

The CMF is currently discussing with relevant parties and insurance companies an amendment to General Rule No.152, through the introduction of General Rule No. 425, with the objective of contributing to the development of the insurance industry by seeking to relax the investment regime governing insurance companies.

Pension funds

The Pension Funds Act,5 the Investment Regime for Pension Funds issued by the Pensions Superintendency and Chapters III.F.3 and III.F.4 of the Compendium authorise pension funds to invest in securities and negotiable instruments authorised by the Pension Superintendency, SAFP, following a prior report from the Central Bank, including structured notes issued by foreign entities (banks and companies). Structured notes issued by foreign entities are defined as hybrid negotiable instruments that combine a fixed and variable income component, the latter being indexed to the return of a certain underlying asset. Structured notes shall be classified by the CCR in a risk rating category of AAA, AA, A or BBB in the case of long-term instruments, or Level 1 (N-1), Level 2 (N-2) or Level 3 (N-3) in the case of short-term instruments, as per the risk rating equivalence determined by the CCR. According to the

4 The Insurance Company Act, Law No. 251.5 The Pension Funds Act (D.L 3.500).


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regulations, an issuer of structured notes must guarantee at least the repayment of 100 per cent of the capital invested. Hence, from this perspective, only structured notes that comply with such requirements may qualify as eligible structured notes for pension funds.

As to the limit on investment in structured notes, this shall in no case exceed 1 per cent of the corresponding fund. The above limit should also include investments in foreign currencies of countries whose sovereign debt is classified in categories below BBB and Level N-3, as appropriate, and that have only one risk classification carried out by a private rating agency, and those of countries that do not have a risk classification.

Finally, among other requirements, the regulations provide that the maximum maturity of notes must not exceed six years, and that the underlying assets may be shares, indexes, currencies, debt instruments, commodities, derivatives, mutual funds, investments funds and funds of hedge funds. There are additional requirements for each underlying asset.

Structured over-the-counter options (ones traded in Chile) shall, at least once a week, provide buying, selling and spread prices in electronic systems of publicly available financial information. In addition to the above, the corresponding pension fund administrator shall provide, at least semi-annually, a report with an opinion on the correct valuation of the instrument drawn up by an independent consulting firm.

Mutual funds and investment funds

The Funds Act6 and General Regulation No. 071 authorise mutual funds managers to enter into option agreements, and future and forward agreements in connection with the assets under management, with clearing houses as counterparts and, in the case of future and option agreements, trades shall be effected in an exchange market (not over the counter). There are certain mutual funds denominated as structured mutual funds that may enter into option agreements over the counter and with counterparts that are not clearing houses, provided that they satisfy certain requirements set forth in the above-mentioned regulations. In connection with forward agreements entered into with a non-Chilean counterpart, General Regulation No. 071 provides that the counterpart shall be a bank, which short-term and long-term debt shall meet certain rating requirements.

There is no reference in the laws and regulations regarding mutual funds and investment funds as to structured notes, as opposed to what has been mentioned above regarding banks and pension funds, although we believe that the current regulations authorise a mutual fund to invest in structured notes subject to the requirements applicable to investments in debt securities abroad. In addition, we believe that investment funds may invest in structured notes, certificates and leveraged certificates provided that their by-laws specifically contemplate such investments as authorised investments, and further provided that they fulfil all other requirements applicable to their investments in debt securities abroad. However, note that these matters are far from being settled in the applicable laws and regulations.

iii Exchange controls

The Central Bank regulates foreign currency transactions by means of the Compendium. Notwithstanding the applicable regulations applicable to banks, as mentioned above, Chilean investors shall comply with the foreign exchange requirements imposed by Chapter XII of the Compendium in the remittance of funds in and out of the country:

6 The Funds Act (Law 20.712).


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a Local residents may freely invest outside Chile in any kind of securities. Payments may be made in foreign currency, which may be purchased in the formal exchange market.

b Whether or not foreign exchange has been purchased in the formal exchange market, pursuant to Chapter XII of the Compendium, the remittance of foreign currency outside of Chile in excess of US$10,000 must be made through the formal exchange market. In connection therewith, a statement generally describing the purpose of an investment must be filed with the Central Bank. Such statement shall also be filed in the case of the use of foreign exchange outside of Chile by a local resident (e.g., funds kept abroad, proceeds from investments). The obligation, however, is vested solely on the investors and not on the local entity.

c Proceeds from the disposition of investments or dividends may be remitted (or not) back to Chile. If remitted, however, the transfer must be made through the formal exchange market, except for amounts lower than US$10,000. Amounts repatriated may be kept in foreign currency or converted into Chilean pesos. If converted into Chilean pesos, conversion must be made in the Formal Exchange Market.7


i Overview

Regarding the marketing of structured products, there is no definition of marketing in Chilean law. Indeed, the laws and regulations refer merely to an offer without giving any definition or giving guidelines. In general, marketing or offer should be understood as any kind of activity to promote securities, to gauge interest in acquiring them or to solicit one or more transactions. Note that investment advice or reports with recommendations to buy specific products (for instance, with the buy/hold/sell categorisation) can be considered to be an offer.

Here, the analysis will depend on the nature of the marketing activities made by either the issuer or local distributor and the range of clients that are intended to be covered in Chile.

Phone calls and mailings

Special care should be taken to avoid the activities of the issuer or local distributor falling within the subject matter scope of the Securities Market Law.

As such, if phone contacts refer to, or the materials sent include, an express or implied offering of securities (e.g., a suggestion to purchase), there exists the risk that, if offered widely or to a certain sector or group of the public, such actions be considered a public offering of securities or brokerage of the same and, thus, would be subject to the Securities Market Law. As previously mentioned, offers of securities addressed to a certain sector or specific group of the public are considered by the Securities Market Law to be public offerings. Therefore, if an issuer or local distributor were to approach all or substantially all investors within a specific

7 The Formal Exchange Market is composed of banks and other entities authorised by the Chilean Central Bank. The Informal Exchange Market is composed of entities that are not expressly authorised to operate in the Formal Exchange Market, such as certain foreign exchange houses and travel agencies, among others. Both the Formal and Informal Exchange Markets are driven by free market forces. The Chilean Central Bank is empowered to require that certain purchases and sales of foreign currencies be carried out on the Formal Exchange Market. Current regulations require that the Chilean Central Bank be informed of certain transactions and that they be effected through the Formal Exchange Market.


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group, it is likely that the CMF would consider such action as a public offering in Chile of unregistered securities. Conversely, if the issuer or local distributor were to approach a small number of prospective clients on an individual basis, the risk of being considered a public offering or brokerage is low and hopefully manageable. Once again, widespread solicitation, even by phone, is prohibited.

Meetings

If meetings with customers in Chile include the offering of offshore securities, whether express or implied, they may only be occasional and infrequent. Multiple meetings with different local investors (e.g., a roadshow) are likely to be considered a public offering of offshore securities or brokerage of the same and, thus, should be avoided.

Documentation

As to the delivery of written materials about offshore securities in Chile, refer to the paragraph about phone calls and mailings.

Website

We believe that the application of the Securities Market Law may not be extended to a website based outside of the Chilean territory, provided that it only refers to offshore securities that are not registered in Chile, and not to securities, domestic or foreign, or certificates that represent foreign securities that are registered with the CMF. The foregoing assumes, of course, that a website will not be addressed solely or principally to customers located in Chile, but rather is made available to anybody with internet access, and that it will be password protected.

Closing transactions

It would be advisable that local entities do not close transactions or issue any kind of receipts, and limit their activities in Chile to the minimum outlined above. For the avoidance of doubt, the closing of transactions and document execution, at least on the side of the issuer, should be done from abroad.

In the case of a private placement, the following rules apply: a Any materials (physical or electronic) shall include a specific wording available in

General Regulation No. 336 or General Regulation No. 345 in order to benefit from the General Regulation No. 345 exemption. There is no specific rule as to where the legend should be placed, but it should be easily seen by the investor.

b The use of mass media is forbidden: for these purposes, mass media include, among others of a similar nature or coverage, press, radio, television and internet, when those media are publicly accessible in or from Chile, regardless of the place where they are produced or from where they are broadcast. However, the following are excluded from this concept: • letters, emails and other communications, physical or electronic, which are

addressed exclusively to a determined person who is duly individualised in the same communication; and

• telephone calls, meetings, personal interviews and electronic systems of restricted access.


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Regarding the distribution of structured products, note that the only synthetic instruments that are traded in the Chilean stock markets are futures, options and Chilean Repos (simultaneas), which are security purchasing operations with buyback clauses. This financing mechanism allows investment in securities without having the required resources through receiving third-party financing for the purchase of shares. The person who provides the financing obtains a fixed and known return in exchange. Nonetheless, it is possible to distribute other synthetic instruments, such as structured products, outside the stock market (over the counter) between customer and stockbroker. Those transactions are done and settled though the Stock Exchange terminals.

In cases where the materials contain misleading information or otherwise contravene the Securities Market Law, the issuer or the distributor, or both, may be subject to administrative sanctions by the CMF. These range from a mere warning (a reprimand by the CMF) to fines.

With respect to fines, the CMF can apply one of the following: a a fine of up to 15,000 Unidades de Fomento (UF),8 which may be trebled up to five

times in the case of repeated offences; b a fine of up to 30 per cent of the value of the issuance, accounting record or irregular

operation; or c a fine of up to the double of the benefits obtained from the issuance, accounting record

or irregular operation.

Moreover, note that if a representative of the issuer or the distributor holding a position as a director or senior executive commits an infraction to the Securities Market Law, the CMF is entitled to disqualify the representative from holding such a position in a Chilean company for a term of up to five years. Courts may also impose periods of imprisonment of up to 15 days, at the CMF’s request, to obtain full compliance with CMF orders requesting disclosure of specific information.

Further note that if the CMF deems that there is a public offering of unregistered securities in Chile, it may file criminal charges against either the issuer or the distributor for violation of securities laws, which may entail up to five years of imprisonment.


There is no trading for structured notes in Chile and, subject to the restrictions outlined above, it is not necessary under Chilean law that any issuer of structured notes be licensed, qualified or entitled to do business in Chile.

As to registration requirements, only Chilean quotas of Chilean structured funds whose underlying investments are structured notes are required to be registered, by the corresponding administrator of such fund, in the Registry of Offshore Securities kept by the CMF and in the Santiago Stock Exchange for trading.

8 The UF is an inflation-indexed Chilean peso-denominated monetary unit calculated by the Central Bank of Chile with a value in Chilean pesos that is adjusted daily to reflect changes in the official consumer price index (Chilean IPC) calculated by the Chilean National Institute of Statistics. The UF is published monthly in the Official Chilean Gazette and is adjusted in monthly cycles. Each day in the period beginning on the 10th day of the current month through the ninth day of the succeeding month, the nominal peso value of the UF is indexed up (or down in the event of deflation) to reflect the variation in the Chilean IPC during the calendar month immediately preceding the period for which such unit is calculated.


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If the marketing and sale of products are subject to the Securities Market Law, it should be borne in mind that there are registration requirements for offshore securities or certificates that represent foreign securities (securities deposit receipts) in the Registry of Offshore Securities kept by the CMF.


Structured notes are not expressly regulated in Chilean legislation. Therefore, the Chilean Income Tax Law (ITL) does not provide a special tax treatment for income resulting from these instruments, and the Chilean IRS has not issued rulings regarding their tax treatment. Given the above, income arising from structured notes obtained by Chilean residents (including interest and capital gains) would be taxed as per the general rules provided by the ITL.

In this regard, as a general rule foreign income received by Chilean-resident entities is subject to a 27 per cent first category tax. Once the income is distributed, it will be subject to final taxes of up to 35 per cent if the partner or shareholder is a Chilean-resident individual (overall income tax); or 35 per cent if the partner or shareholder is a foreign entity or individual (withholding tax), in which case the Chilean-resident entity is responsible for its withholding. Against the applicable final tax, 65 per cent of the first category tax paid can be credited (resulting in a maximum effective rate of 44.45 per cent) unless the partner or shareholder is an individual or entity resident in a foreign country with which Chile has a double taxation treaty currently in force (or, up to 31 December 2021, signed but not yet in force), in which case the first category tax can be fully credited against the aforementioned final tax.

Foreign income received by Chilean-resident individuals is subject to final taxes of up to 35 per cent. If the income arising from structured notes is considered to be securities income, as established in Article 20 No. 2 of the ITL, then it would be also subject to a 25 per cent first category tax, which can be fully credited against the aforementioned final taxes.

Foreign taxes levied and paid over the income arising from structured notes may also be credited against Chilean taxes, provided that certain requirements set forth in the ITL are met and within the limits established therein.

The aforementioned tax treatment may differ if a double taxation treaty applies. Should this be the case, income taxation may vary depending on how the income is classified (e.g., interest, business profits) as per the particular characteristics and associated risks of each structured note, and according to the rules set forth for each type of income in the corresponding treaty. Therefore, in this case the tax treatment applicable to the income arising from structured notes should be determined on a case-by-case basis.

VI OTHER ISSUES

Although there is no case law on the subject matter, there might be a risk of recharacterisation each time a new instrument or product raises Chilean public policy issues (for instance, a Chilean court may consider that certain TRSs are collateralised loans that have been structured as a TRS to avoid Chilean prohibitions on self-help remedies) or tax issues (for instance, the IRS may consider that in connection with leveraged certificates, a portion of the payment made by the investor should be subject to withholding taxes as it would correspond to the payment of interest on an offshore loan). This risk should be assessed on a case-by-case basis.


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Chapter 3

FINLAND

Mika J Lehtimäki1

I OVERVIEW

The Finnish structured products market differs quite a bit from the other European markets in terms of the typical products and size. The Finnish Structured Products Association (FSPA) tracks market movements and promotes good market practice in offering and dealing in structured products. The level of market activity in 2018 was roughly at the same level as that seen in 2017. The low interest rate environment resulted in low sales volumes of capital protected products. Structured products that are linked to credit risk also became more popular as a result. Equity shares represented the largest underlying reference asset, followed closely by credit risk instruments. Interest rate, commodity currency, strategy and hybrid all represented a marginal part of the markets.

The total volume of new sales in 2018 was around €1.3 billion, which amount has been reducing for the past few years. This figure makes up circa one-third of the new sales of undertakings for collective investment in transferable securities (UCITS) funds. Initially it was expected that changes in the EU legislation that came into effect in 2018 would have reduced the level considerably, but after an initial adjustment to the Mifid II and packaged retail and insurance-based investment products (PRIIPS) rules, the volumes rose back to their usual levels.2

The most common structured products in the Finnish markets are: a equity linked bonds on several levels of capital protection; b certificates: mainly index certificates, bonus certificates (e.g., S&P 500-linked), coupon

certificates (autocall) and credit certificates (e.g., credit default swaps), often iTraxx Crossover index-linked; and

c warrants.

The distribution between public offers and private placements of structured products in 2018 was approximately half and half. There was no issuance of certificates of deposits.3

The largest issuers in Finland in 2018 were Nordea Bank, Danske Bank, Alexandria Pankkiiriliike, SEB and OP Group.4 These parties also represent some of the largest distributors. However, there are no established statistics on structured products distribution.

1 Mika J Lehtimäki is a partner at Attorneys-at-Law TRUST Ltd.2 FSPA: ‘Strukturoitujen sijoitustuotteiden myynti vuonna 2018’, press release 31 January 2019.3 Ibidem.4 Ibidem.


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The first half of 2019 showed a clear rise in the sale of structured products, with equity-linked products leading the growth. Generally, and due to the continuing negative interest rate environment, various market development linked products were strongly represented.


The most important legal and regulatory aspects relating to structured products are securities law disclosure and prospectus obligations, their status under the investment services legislation (i.e., the product governance and disclosure rules), and potential damages and liability rules, as well as the tax treatment of derivatives and derivatives embedded securities in personal and corporate taxation.

The main supervisory bodies in Finland are the Finnish Financial Services Authority (FSA) (mainly prospectuses and investment services, and banking law compliance and registries), the Bank of Finland (certain reporting obligations) and the European Securities Markets Authority (ESMA), which in practice adopts rules and regulations if allowed under EU law. The listing and disclosure rules of Nasdaq are also relevant to all issuers of listed structured products in Finland.

As previously mentioned, approximately half of all Finnish-issued structured products are offered publicly, and it is very commonplace to list the products, often on Nasdaq Helsinki list or Nasdaq First North (for certain structured leveraged products). In some cases, Finnish issuers may seek listing in, for example, Ireland or Luxembourg. However, the focus of this chapter is domestic listing.

Issuers will have to prepare a prospectus in accordance with the EU Prospectus Regulation5 either if the securities they offer are offered to the public or listed on a stock exchange. As of July 2019, the minimum threshold for triggering the prospectus requirement is €8 million. However, there is a possibility to publish a prospectus also in relation to offers between €1 million and €8 million. These offers are subject to more lenient requirements. If an offering and securities are not listed, the offer may still be subject to the pan-European prospectus exemptions. The most common of these are the offering of securities to less than 150 persons, or only to qualified persons in addition to the maximum of 150 other investors, or if the minimum initial subscription value or nominal value is at least €100,000. The prospectus and post-offering disclosure regimes are well settled, and there are no major uncertainties in the process of drafting. However, we expect that some of the new EU prospectus requirements implemented in July 2019 will create a need to reevaluate structured products disclosures. These concern the more detailed rules for the prospectus summary, and the new, more security and issuer-specific risk descriptions. Furthermore, we expect that the possibility to file the universal registration document every financial year will ease consecutive offerings of structured products, and in any case shorten the approval process of a prospectus to five working days. This may prove to be especially useful for frequent issuers of structured products.

In practice, for a large part of the structured products offered and distributed by the institutions active in Finland (mostly banks) that are listed on Nasdaq Helsinki, the offering will exceed the minimum thresholds and the issuer, therefore, will have a prospectus approved by the FSA, and publish it after approval. The EU securities legislation enables the use of a base

5 Regulation (EU) 2017/1129, June 2017.


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prospectus, which is often the most common choice of issuers. They will supplement the base prospectus with a pricing supplement and a summary in connection with individual offerings. All of the prospectus filings and the documentation are available on the FSA website.

In addition to the documents required by the securities legislation, issuers will have to supplement the materials with a key investor information document (KIID), which in practice all issuers of structured products will have to prepare when offering such products to retail customers.6 This requirement and the risk definitions of the KIID legislation have caused, especially during 2018, some concern among issuers that the statutory risk categories do not correctly reflect the underlying risk, which statutory category may also result in differing categorisations for similar products. KIIDs will have to be given to investors in good time before the investors become bound by a planned transaction. Although the FSA has issued a statement that an English KIID may be approved in certain situations, due to existing case law, issuers and distributors should be very attentive to the clarity and contents of a KIID and the additional investment advice, which risk may be pronounced when using a foreign language document.

Issuers of structured products should also take into consideration the EU Benchmark Regulation,7 which requires supervised entities to ensure that there are contractual mechanisms to change the benchmark (i.e., reference or a rate) if there are regulatory or certain commercial reasons why the initial benchmark is no longer available or cannot be used. We are seeing gradual implementation of the Benchmarks Regulation into the terms of products.

In practice, Finnish issuers of structured products are banks. However, they can also be, inter alia, investment services companies, which means that they will have to have an investment services licence to be able to offer services in Finland. Technically, portfolio management, trading in own account, brokerage and equivalent activities in relation to structured products can also be carried out by alternative investment funds and UCITS management companies. Irrespective of the issuer and the distributor, the Finnish Investment Services Act8 regulates, inter alia, product governance, customer categorisation, conflict situations and inducements relating to structured products. The relevant Finnish law is based on the EU MiFID legislation,9 which due to its recent further harmonisation is similar to the EU rules. Some of these are discussed in the next section.

There is no notable case law concerning the offering of specifically structured products. However, the FSA has shown considerable interest in suitability analysis and know your customer (KYC) requirements as well as documentation requirements and defects in relation to structured products and financial advice concerning structured products. In 2015 and 2016, the FSA investigated several banks and how they fulfilled their duties in relation to KYC regulations and obligations to assess the suitability of certain investment products in their investment services operations. The FSA ended up issuing fines and public warnings to four of the biggest banks, with the largest individual fine being €1 million. Deficiencies were found especially in the offering of structured products to elderly investors who were incapable of assessing the related risks, in documentation and in the actual carrying out of the suitability

6 The rules are based on the Packaged Retail and Insurance-based Investment Products Regulation (EU) No. 1286/2014.

7 Regulation (EU) 2016/1011, 8 June 2016.8 Investment Services Act 747/2012, as amended.9 Especially Directive (EU) 2014/65/EU, 15 May 2014 (Mifid II) and Regulation (EU) No. 600/2014,

15 May 2014 (MifiR).


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analysis. The FSA also emphasised the lack of adequate conflict management measures at some of the companies. Following extensive FSA intervention, we have seen especially that the sales measures, disclosure and suitability analysis of various market participants have strengthened. Furthermore, the FSPA also places more and more emphasis on the promotion of good conduct in the markets. The FSA seems to be very attentive to the issuance and offering procedures in relation to structured products and, especially after the implementation of the more stringent and detailed MiFID II rules in Finland, the compliance function of structured products issuance and sales will have to be duly managed and always well documented.

The International Organization of Securities Commissions recommendations on retail structured products are reflected in Finnish law through the recent changes in EU financial services legislation. Furthermore, the bank capital and liquidity rules relevant especially in the valuation and risk assessment of structured products is a part of the EU banking and financial services legislation, which is harmonised within the EU, including Finland.


i Product governance

The legal aspects of the offering process are determined to a large degree by the requirements of the Investment Services Act, FSA Regulation and Guidance 7/2018 on the Arrangement of Operations and Codes of Conduct of Investment Services as well as the European Securities and Markets Authority (ESMA) Guidelines on the MiFID II Directive Product Governance Requirements10 and the ESMA Guidelines on Complex Debt Instruments and Structured Deposits.11 Finnish law corresponds to a large degree with the MiFID legislation, albeit with some deviations in the FSA’s guidance.

Both banks and investment services companies that ‘manufacture’ financial instruments, including structured products, will have to have a current product governance procedure and mechanisms in place to ensure the management of conflicts of interests with customers, including applicable compensation structures. The structuring should not have negative effects on the final customers, and the process should not be used, inter alia, to reduce a company’s own exposure to the target or relevant financial instruments or assets, and opposing positions of the financial instruments should be avoided. Manufacturers will have to define the potential target investor base and customer types to ensure that their needs, qualifications and objectives make the financial instruments suitable for them, and must also carry out an analysis of scenarios that might occur in various circumstances. In practice, the last requirement is also very important in relation to a number of structured products. If a manufacturer does not distribute the instrument itself, the same determination will have to be made based on theoretical factors and past experiences. This analysis will have to be disclosed to the distributors of the products, and they will have to specify the same attributes in their own operations. The fact that the Investment Services Act requires that a financial instrument offered or recommended to a customer must be in the interests of the customer means that usually the disclosure concerning the product’s characteristics and a careful evaluation of the suitability and the target investor base determination are both pronounced for structured products. Understanding the risk structures is paramount due to the complexity of some products.

10 ESMA35-43-620.11 ESMA/2015/1787.


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The obligations of distributors of structured products (which are similar to those of manufacturers, but more specific) can only be fulfilled if they receive sufficient information from manufacturers. This means that distribution agreements must contain a detailed list of the parties’ obligations and liabilities. It is the distributor’s obligation to ensure the relevant structured products are compatible with the requirements, attributes and objectives of the specified target investor group. Noting the diversified underlying reference asset base of some structured products, if the information is not received from the manufacturer in full, the distributor will have an obligation to get the information primarily from statutory public disclosure, which the FSA is likely to review if there are legal concerns over the fulfilment of the product governance obligations. The distribution strategy will have to take into consideration the due disclosure of information, and further evaluate the compatibility and appropriateness of the product in relation to the specified target investor group, inducements on the part of the financial firm towards that group and the conflict management obligations. The customer and target investor analysis will have to comply with the categorisation set out in ESMA Guidance on MiFID Product Governance Requirements.12 It should be noted that the distributor’s obligation to define the target investor market more specifically than the manufacturer is especially relevant for complex financial instruments such as structured products.

One of the few explicit requirements regarding the external compliance functions of manufacturers and distributors of financial products is that board-approved product governance documents and decisions must appear in the compliance report itself. Because the document is also made available to the FSA upon demand, we expect that product governance decisions and policies will be more rigorously scrutinised by boards, potentially clearing an avenue for the FSA to commence market reviews, and to review individual companies and industry participants. Because not all market participants may have allocated sufficient resources to this topic, and new regulations such as the PRIIPS Regulation include a level of vagueness regarding, for example, risk categorisations, a risk of statutory liability and potential sanctions currently exists. Apart from recent FSA investigations, there is not much case law relating to product governance obligations. However, due to the specific nature of the existing regulation, the obligations are fairly settled.

The question of execution-only investment services in relation to complex products is regulated separately. The banks’ and other structured products distributors’ obligation to carry out a compatibility and suitability evaluation of their customers does not apply in most cases in relation to retail clients if a transaction is provided on an execution-only basis (i.e., the execution or reception and transmission of orders). However, this is not possible under the Investment Services Act, for example, in relation to most derivative instruments or complex products. ESMA issued guidelines regarding the definition of such complex products in 2015.13 The ESMA guidelines are not exclusive, but do in practice cover most of the structured products available. Therefore, a distributor of structured products, even in execution-only transactions, will have to carry out an analysis when dealing with retail clients.

ii KYC and anti‑money laundering rules

The Finnish KYC rules have undergone a material change over the past two years, mainly as a result of the revised Act on Prohibition of Money-laundering and Financing of Terrorist

12 ESMA35-43-620 FI, 5 February 2018.13 ESMA/2015/1783, 26 November 2015.


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Activities in mid-2017. In practice, most parts of the Act are relevant for banks and financial services firms dealing with their counterparties in structured products. However, the law is based on the harmonised EU legislation, and there are no major additional obligations compared to the EU level rules.

The KYC rules are based on a bank’s obligation to verify a client, its lawful representatives and status. The additional obligation to know a client is intended to evaluate and track the client’s business and operations on the level of the risks connected to the particular client from the anti-money laundering perspective. The client-specific risk evaluation is additional to the evaluations carried out under the MiFID obligations and rules. If the initial risk evaluation evidences a requirement to carry out a ‘strengthened knowledge procedure’, the review concerning the origin and objectives of the client’s transactions is more extensive. The statutory evaluation of the bank may lead, if there is reason to suspect breach of the relevant legislation, to the obligation of the bank to notify the Anti-Money Laundering Supervision Centre. The threshold for making the filing is relatively low in Finland. However, there is nothing in structured products themselves making them more susceptible to anti-money laundering claims. All banks and financial services companies are obligated to approve internal risk evaluation policies, and the use of inherently complex products or transactions will have to be considered in such a risk evaluation policy. Breach of these obligations may lead to a fine of up to €5 million.

The anti-money laundering rules were amended again in May 2019, increasing notably the list of items that banks and financial services firms will have to include in their KYC and customer risk evaluations. Furthermore, Finnish law changes as of 2019 concerning obligations of various entities to register their ultimate beneficial owners in the Trade Register were extended logically into the anti-money laundering legislation by extending the KYC and customer risk analysis obligations to the ultimate beneficial owners and through the legal ownership chain. As the main rule, a person is the beneficial owner under Finnish law if he or she holds over 25 per cent of the ownership or control of an entity. While the law does not treat transactions dealing with structured products differently from transactions in other financial instruments, some market actors are likely to use in their customer risk analysis and follow-up queries their policies concerning complex transactions, especially if a transaction is over-the-counter (OTC) and part of a more complicated arrangement.


The main market for listing and trading in structured products in Finland is Nasdaq Helsinki. Almost all of the listed structured products are issued by banks, and are in most cases part of an issuance programme under which a bank can offer and list individually separate structured product issues using a pricing supplement and the summary.

The most common category is listed retail structured bonds. It is possible to list also structured products units, but there are currently no such listings. A few issuers list have also listed structured leveraged products in Nasdaq First North list, which is not a stock exchange list but an alternative market subject to more lenient regulation. Other listed structured products in Nasdaq include leverage and tracker certificates, common certificates, warrants and ‘knocked-out instruments’, which can technically also be considered structured products. Technically, most of these instruments are listed and traded on the Nasdaq Nordic Market, which includes also other Nordic countries. Compared to the closest market, Sweden, the scope of listed structured products is notably smaller.


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Access to trading in Finnish listed structured products is possible through registered intermediaries or through a chain of financial intermediaries, as with most other markets. There is a wide selection of financial services companies and banks active in the markets or connected directly to the registered intermediaries. Therefore, access to trading in the markets is easy.


There is no asset transfer tax or sales tax in Finland that would affect the offering or sale of structured products. Theoretically, some physically settled equity linked securities that are linked to unlisted shares may result in a transfer tax obligation. However, we have seen no such typical structured products, and the obligation is relevant primarily with convertible securities. The relevant tax rules are complex, but we discuss certain relevant Finnish law questions below.

i Personal income and business income tax separation

The main tax aspects of structured products relate to the determination of whether a business or the securities operations of a business fall under the Finnish Income Tax Act or the Finnish Business Income Tax Act. As a general rule, the former applies to individual persons and certain businesses carrying out ancillary securities operations, if the securities business is not considered to fall under the Business Income Tax Act. Determination of the correct tax statute always requires a case-by-case analysis. However, active securities trading by companies is usually categorised as business income, whereas passive or long-term holdings may be considered to belong to the personal income category. Securities trading by individuals is not usually regarded as business income for tax purposes if it is an ancillary or non-main activity of the person. However, it is very likely that the tax act categorisation will be changed materially in 2020.

Given the above, below is a discussion of some aspects of tax law relevant to structured products under both income tax categories. The categorisation is important especially when determining losses incurred.

On the personal tax side, transfer or capital losses can be deducted during the relevant year or the next five years from similar profits. Losses can generally be deducted more easily if they fall under the Business Income Tax Act. In such a case, losses can generally be deducted from other business profits within the next 10 years. However, the right to make deductions depends on the categorisation of the relevant securities. Deduction for securities belonging to inventory or financial assets is not generally restricted, but deductions for securities deemed as fixed assets is if the sale would have been tax-free. However, if such a sale would have been taxable, losses can be deducted from profits based on the sale of similar assets during that year and the next five years.

The deductibility of bond interest payments is usually treated as a normal deductible business expense. However, the treatment of embedded derivatives such as options is treated differently, so the basic rules are discussed below.

ii Derivative instruments under Business Income Tax Act

It would be logical to consider structured products under tax law as securities, which would mean that they should be subject to the capital income taxation rules. However, this is not always the case.


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There is not much case law on taxation of warrants and certificates, and the authorities are likely to apply the tax rules applying to options by analogy. Some market participants have argued that this may lead to unexpected tax law consequences. However, noting these concerns, the relevant main rules applying to the taxation of options are described below.

The premium received by the seller of an option, if the option is either traded OTC or the maturity exceeds 18 months and the option is listed on a regulated market, is taxed during the financial year of the issuance of the option.

However, if the option is listed and cash-settled, but the maturity is less than 18 months, the premium received by the issuer is taxed in the financial year of the closing of the position, exercise or expiration of the option. If a put option falling under the same rules is not cash-settled, the deductible acquisition price under tax law is the purchase price less the premium.

If the option is cash-settled, the premium is considered to be an expense for the holder of the option deductible for the financial year of closing, exercise or expiration of the option. However, if a call option is not cash-settled, the acquisition expense under the tax law includes the purchase price plus the premium. If the issuer of a put option purchases the reference security, the deductible acquisition expense includes the purchase price plus the premium.

It should be noted that certain structured products should be recorded in the income statement in accordance with their fair value, irrespective of the fact that the income would not be realised at that point. This means that the calculated taxable value appreciation or taxable deduction will change in accordance with the fair value developments if the structured products are part of the trading inventory of a bank or a financial firm if it is subject to international accounting standards. Similar rules apply generally to structured products if the entity is a credit institution, to insurance and pension institutions in relation to the financial instruments part of their trading inventory, and in a more limited scope to insurance companies. The tax analysis of tax income effects of structured products requires case-by-case analysis of the International Accounting Standards rules and the domestic tax law. In a number of cases it is advisable to seek an advance ruling from the tax authorities.

iii Certain structured products and the Personal Income Tax Act

The most common Finnish structured products are ‘investment obligations’ consisting of a bond and a derivative product. For individuals, the income paid at maturity (index payment, i.e., the income paid at the time of the redemption of the instrument) is considered capital income and treated similarly to interest income. The current capital income tax rate is 30 per cent, or 34 per cent if the income exceeds €30,000. The payor, if the recipient is a Finnish person, if the debtor is a Finnish entity and if the financial instrument is listed on a stock exchange, makes a tax withdrawal at source, which is also the final tax. In other situations, the recipient declares and pays the capital income tax. Finland has an extensive tax treaty network that regulates cross-border situations. When selling an investment obligation or upon its redemption, any profit or loss is calculated according to the capital gains tax rules.

If an index-linked bond is not capital-secured, and the conditions for payment of the capital is not fulfilled, whether partially or in full, the loss is considered final for tax purposes and is therefore considered a capital loss in taxation. Possible nominal interest, the secondary-market compensation (calculated but unpaid interest, when the instrument is transferred before maturity or redemption) and the index consideration (i.e., the profit linked to the reference asset paid at maturity if the conditions are fulfilled) are an exception, and they are considered capital income.


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All other income received, for example due to an appreciation of value, is deemed taxable capital gains. The issue price and the expenses or the secondary market acquisition price less the secondary-market compensation is considered to be the acquisition price under tax law. The transfer price less the acquisition consideration is taxed as capital gains. Even if an index-linked bond is a zero-interest instrument, the difference between the acquisition and redemption price is deemed as a capital gain (or loss). The same applies to bonds subscribed below the nominal rate.

This also applies with a number of other structured products such as reverse convertibles. In that case, a change in the value of an asset is capital gains (loss), any possible coupon interest is usually subject to tax withdrawal at source and the secondary-market compensation is taxed as interest income.

iv Certain structured products under the Income Tax Act

Income (e.g., a premium) based on options is considered generally a part of capital gains taxation. If the options are not cash-settled, the option premiums are calculated into the acquisition or sales price in determining the taxable capital gains.

Profit based on listed futures is considered taxable as capital gains. Unlisted futures are, however, subject to capital income taxation (i.e., the capital gains tax rules are not applied). Notably, incurred losses, subject to some exceptions, are non-deductible in taxation.

Income based on contracts for differences is considered taxable as capital gains. However, the corresponding losses are not considered as incurred for purposes of obtaining income and are not deductible under capital gains taxation.

Warrants that are listed on a regulated market are subject to the capital gains tax rules of the Income Tax Act. In practice, Finnish-listed warrants are cash-settled, so the taxable gain is the cash payment less the acquisition cost or an acquisition-cost assumption amount, whichever is more beneficial. If the warrant expires, it can be considered a final loss of the value of the security under tax law. Although, there is no case law in the matter, the tax treatment of certificates follows generally that of warrants.

VI OTHER ISSUES

As a result of the FSA investigations into the offering of structured products to, among others, elderly persons, which led to major fines issued to the biggest market actors, it is likely that this matter will be pronounced going forward. Combined with the recent product governance changes, it is likely that the FSA will continue investigating especially the fulfilment of the customer categorisation obligations, and distribution strategies and the consistency of the actual sales measures compared to these obligations and the transparency requirements.


Although, the regulatory landscape is, as a result of the recent EU law changes, fairly settled, some of the civil law, for example regarding damages and disclosure liabilities, is not well settled. We expect that the FSA will be attentive to the new rules and is likely to conduct market-wide investigations that may result in statutory fines, warnings and possible civil litigation. To control these risks, it is advisable for market participants to focus especially on transparent risk disclosure, strict adherence to and review of the product governance rules and disclaimers, and documenting client communications throughout.


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Chapter 4

JAPAN

Naoya Ariyoshi, Toshiyuki Yamamoto and Yuki Taguchi1

I OVERVIEW

The Japanese structured products market has a long history and is still active, although no official statistics are available. For retail investors, running a search on EDINET,2 the Japanese equivalent to the US EDGAR, will find many derivatives-embedded securities linked to exposure to Nikkei Stock Average (Nikkei 225) and FX transactions. According to one publicly available source, the outstanding amount of Nikkei 225 linked bonds appeared to be over ¥1 trillion in the latter part of 2018. Banks also offer structured deposits to retail customers. Further, on the institutional investor front, similar or more complex types of structured products linked to stock indices and FX transactions, such as power reverse dual bonds, reverse floater bonds and constant maturity swap bonds, are offered.

The structured products described above are typically issued by foreign financial institutions (including foreign subsidiaries of Japanese financial institutions) pursuant to foreign laws and offered to investors in Japan. The structure of trust bonds established pursuant to Japanese law is also seen (as discussed further in Section II). Additionally, we understand that offshore vehicles are utilised to issue structured bonds.

For public offerings (typically sold to retail investors), securities registration statements are filed (see Section III). Domestic and foreign bonds fall under the definition of securities under Article 2, Paragraph 1 of the Financial Instruments and Exchange Act of Japan (FIEA) (Paragraph 1 securities). If this is the case, a financial instruments business operator that conducts a Type I business registered pursuant to the FIEA (Type I business operator) generally distributes bonds to investors.


i Types of structure

Japanese structured products (issuing bonds3) are differentiated into two types.Under one typical structure, a going-concern issuer such as a foreign financial institution

issues bonds whose terms and conditions already have derivatives features embedded (issuer

1 Naoya Ariyoshi is a partner and Toshiyuki Yamamoto and Yuki Taguchi are associates at Nishimura & Asahi.2 http://disclosure.edinet-fsa.go.jp/.3 We understand that structured loans, whose economics are similar to structured bonds, are also popular

products in Japan.


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bonds). The issuer will enter into back-to-back derivatives transactions with a dealer for hedging purposes. The issuer bonds are typically governed by the foreign law where the issuer is located; for example, if the issuer is located in the UK, English law governs.

Under another typical structure, an arranger sets up a bankruptcy-remote special purpose vehicle (SPV), and that SPV issues bonds to investors and enters into derivatives transactions with a swap counterparty (SPV bonds). In Japan, trusts under the Trust Act of Japan (Trust Act) are utilised as vehicles for issuing bonds, in addition to SPVs established offshore, such as in the Cayman Islands, issuing bonds pursuant to foreign laws such as English law. For SPV bonds, the issue amount from investors will be invested in a safe underlying asset such as Japanese government bonds. For the purpose of matching cashflows between the SPV bonds and the underlying assets, derivatives transactions are used and the swap counterparty provides cashflow tailored to payments of the principal and interest of the SPV bonds.

From a credit risk perspective, investors in issuer bonds are subject to the credit risk of the issuer. On the other hand, investors in SPV bonds are subject to the credit risks of both the swap counterparty and the issuer of the underlying bonds.

ii Trust bonds

As the trust structure is Japan-specific, we would like to elaborate on trust bonds as follows. Under the Companies Act of Japan (Companies Act), a trust bond is defined as ‘a bond that the trustee of a trust issues, which is issued for trust property (meaning the trust property established in Article 2, Paragraph 3 of the Trust Act)’ (Article 2, Paragraph 3, Item 17 of the Regulation for Enforcement of the Companies Act).

An issuer of trust bonds is typically a trust bank. An arranger, as trustor, and a trust bank, as trustee, enter into a trust agreement. The initial trust property paid by the arranger is nominal cash. The trust bank issues trust bonds for the trust property, and the issue amount of the trust bonds comprises the trust properties under the trust agreement. The issue amount will be invested in a safe underlying asset such as Japanese government bonds, and the trust bank also enters into a swap agreement with the arranger to generate cashflow of the interest and principal of the trust bond linked to, for instance, a stock index. Issuance of the trust bonds is based on limited recourse clauses so that the obligations of the trust bank (issuer) are limited to the trust property of the trust bonds only. To protect the structure, there is also a prohibition against filing for the commencement of bankruptcy proceedings for the trust property stipulated in the trust agreement.

Pursuant to Article 25, Paragraphs 1, 4 and 7 of the Trust Act, even where a trust bank is subject to bankruptcy, rehabilitation or reorganisation proceedings, the trust property will not be subject to such proceedings. In other words, the trust property is independent from the credit risk of the trust bank so long as the trust bank complies with its legal obligations as a trustee. Thus, investors in trust bonds are limited to the credit risks of both the swap counterparty and the issuer of the underlying bonds.

Issuance of trust bonds is subject to the Companies Act. The trust bond is treated as a corporate bond under Article 2, Paragraph 1, Item 5 of the FIEA. Thus, disclosure of the publicly offered trust bond is subject to the statutory process pursuant to the FIEA, the relevant enforcement order and cabinet office ordinances. It is possible that the Act on


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Book-Entry Transfer of Corporate Bonds and Shares of Japan will apply to trust bonds, whereby the trust bonds are handled by the book-entry transfer system operated by the Japan Securities Depository Center, Incorporated (JASDEC).4

iii Japanese law applications and the regulator

Laws and regulations applicable to distributions of structured products

When Type I business operators distribute structured products that are Paragraph 1 securities to investors, the applicability of the FIEA has to be considered from several perspectives. The supervisory body for Type I business operators is the Financial Services Agency of Japan (JFSA). The FIEA stipulates numerous regulations applicable to distributions of structured products, including, without limitation:a a duty of sincerity to customers (Article 36);b regulation of advertising (Article 37);c delivery of documents both prior to the conclusion of a contract and upon the

conclusion of a contract (Articles 37-3 and 37-4);d an obligation to conclude a contract with a designated dispute resolution organisation

(Article 37-7);e prohibited acts (Article 38);f a prohibition on compensation of loss (Article 39); andg the principle of suitability (Article 40).

However, some of these regulations are exempt if customers are classified as professional investors. Professional investors include qualified institutional investors (such as banks and insurance companies), the state and the Bank of Japan (BoJ). Listed companies and stock companies whose stated capital is expected to be ¥500 million or more are also included, but they can be treated as non-professional investors if they would like to be so by applying the statutory procedures. On the other hand, corporations that are originally classified as non-professional investors as well as certain high-net-worth individuals can be treated as professional investors if they would like to be so by applying the statutory procedures.

The Act on Sales, etc., of Financial Instruments of Japan (Sales Act) also provides investor protection mechanisms by forcing financial instruments providers, including Type I business operators, to explain statutorily important matters to customers. Important matters under the Sales Act include a risk of principal losses, indicators that lead to principal losses due to fluctuations and important portions of the structure of transactions. Financial instruments providers are also prohibited from providing customers with conclusive evaluations on uncertain matters or with information that misleads them into believing that uncertain matters are certain. If financial instruments providers fail to comply with the above obligations, the Sales Act stipulates clauses concerning liability for damages and presumptions concerning the amount of loss that provide customers with easier damage claims as compared to those under tort pursuant to the Civil Code of Japan. An explanation of the important matters pursuant to the Sales Act will not be necessary if customers are specified customers that overlap with professional investors as stipulated under the FIEA, or if the customers have manifestly expressed that they do not require such an explanation.

4 http://www.jasdec.com/en/.


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Laws and regulations applicable to structured deposits

Structured deposits offered by banks are regulated by the Banking Act of Japan (Banking Act). The Banking Act stipulates that structured deposits are specified deposits. Specified deposits are defined as ‘deposits or instalment savings, etc., that carry the risk of a loss of the principal due to fluctuations in the money rate, value of currencies, quotations on a financial instruments market as prescribed in Article 2, paragraph 14 of the FIEA, or any other index’, and more precise specifications are provided by the delegated Regulation for Enforcement of the Banking Act. The following fall under specified deposits:a deposits that require that a penalty be paid or other conditions equivalent to this when

a depositor terminates the deposit before maturity, and that the amount, as a result of deducting the amount of said penalty from the balance of said deposit at the time of said termination, is likely to fall below the deposited amount due to changes in money rates, values of currencies, quotations on a financial instruments market and other indexes;

b deposits that are indicated in a foreign currency; andc deposits for which a currency option transaction is incidental.

The investor protection mechanism under the FIEA described above in addition to the termination of contracts during a statutory cooling-off period generally apply mutatis mutandis to a bank’s conclusion of contracts for specified deposits. The Sales Act described above is also applicable.

iv Margin requirements for non‑centrally cleared derivatives

The Basel Committee on Banking Supervision and International Organization of Securities Commissions’ margin requirements for non-centrally cleared derivatives have been implemented in Japan since September 2016 via the two separate channels of the FIEA and the supervisory guidelines of the JFSA (collectively, the Japanese MR). Under the Japanese MR, a trust formed by a trust bank (as a trustee) that is a registered financial institution under the FIEA is subject to the Japanese MR if certain conditions are met, such as that a swap counterparty is also a financial instruments business operator or a registered financial institution,5 and that the swap agreement is a non-cleared over-the-counter (OTC) derivatives transaction for FIEA purposes. The JFSA’s response to consultations concerning the relevant draft regulations (public comments) mentions that even if a trust account is used as a repackaged vehicle, no special exemption is scheduled to be implemented.6 Generally, even in a trust bond structure, depending on the swap exposure, the trust bank posts underlying assets to the swap counterparty (and receives collateral from the swap counterparty) as a variation margin.

5 As to a foreign swap counterparty, ‘a person engaged in OTC derivatives transactions in the course of trade in a foreign state’ is subject to the Japanese MR. Thus, in general, foreign financial institutions serving as swap counterparties are subject to the Japanese MR. However, note that foreign states here are limited to those where close-out netting or any similar clauses are appropriately confirmed to be effective in light of laws and regulations of such foreign states.

6 See No. 41 on page 7 available at https://www.fsa.go.jp/news/27/syouken/20151211-1/01.pdf (Japanese only).


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On the other hand, when responding to the question about derivatives transactions embedded in deposits or loans, the JFSA has responded that the Japanese MR will not be applicable if OTC derivatives transactions are integrated with deposits or loans, which are the major factors in transactions.7


i What is a public offering?

In general, an offering by an offshore issuer of newly issued debt securities in Japan is treated as a public offering under the FIEA if the number of offerees (excluding certain qualified institutional investors) in Japan is 50 or more.8 Thus, an offering of structured products that targets retail investors in Japan would constitute a public offering, and private deals targeted at professional investors only or a small number of investors could rely on private placement exemptions.

There have been no significant amendments of the relevant securities laws in recent years. As such, a general overview of public offerings and private placements of debt securities is provided in subsections ii and iii.

ii Public offering process

In the case of a public offering of newly issued debt securities, if the aggregate offer price in the proposed offering in Japan is ¥100 million or more,9 the issuer must file a securities registration statement (SRS) with the Director General of the Kanto Local Finance Bureau with respect to the proposed offering in Japan.10 The SRS must include comprehensive information regarding the offered securities and the issuer (e.g., an SRS for trust bonds must contain the structure of the trust, the status of underlying assets, risk factors, financial information of both trustor and trustee, and similar information). The SRS will be publicly disclosed on EDINET. As a general rule, the SRS will become effective 16 days after it is filed, and the issuer cannot start offering until then. When the issuer is subject to continuous disclosure requirements under the FIEA (i.e., the issuer made public offerings in Japan in the past), the waiting period for the SRS can be shortened to approximately seven days. In addition, such issuer can file a shelf registration statement instead of an SRS to achieve a more flexible offering through the shelf registration system.

The issuer in a public offering must deliver a prospectus to each offeree with respect to the proposed offering in Japan. The prospectus must contain certain items regarding offered

7 See No. 7 on page 2 available at https://www.fsa.go.jp/news/27/syouken/20160331-4/01.pdf (Japanese only).

8 However, in cases where structured products are created in the form of trust beneficiary interests without beneficiary certificates, the offering of such newly issued structured products (i.e., an offering of securities other than Paragraph 1 securities) is treated as a public offering if the number of parties acquiring such interests (excluding certain qualified institutional investors) in Japan is 500 or more.

9 If the same kind of debt securities (i.e., securities with the same maturity, coupon and currency) were offered in Japan during the past one year, the aggregate offer price in the past offering is also counted for the purpose of the ¥100 million threshold, although it is unlikely to occur in the context of debt securities.

10 If the amount ranges from ¥10 million to ¥100 million, the issuer must file a securities notice with the Director General of the Kanto Local Finance Bureau, which is simpler than an SRS and is not publicly disclosed.


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securities and the issuer in accordance with the FIEA. In practice, since most debt securities are sold through OTC transactions, securities companies as distributors for offered securities deliver a prospectus to potential investors.

iii Private placement process

In cases where issuers rely on the private placement exemptions discussed in subsection i, there are no filing requirements under the FIEA. On the other hand, issuers must notify offerees that no SRS has been filed in relation to the private placements. Delivery of a prospectus is not a requirement under the FIEA for a private placement, but in practice issuers prepare a prospectus in concert with arrangers and deliver it to investors even when the products being offered in the private placement are tailored for a single investor. This is because the FIEA requires that Type I business operators as distributors deliver certain documents to their clients prior to and upon the conclusion of a sale and purchase agreement for securities (see Section II.iii).

iv Investor identification

Under the Act on Prevention of Transfer of Criminal Proceeds of Japan (APTCP), a financial institution, including a bank or a securities company, is required to identify and verify its customers when conducting individual transactions with them. In principle, customer identification documents, the purpose for conducting the transaction and other information is necessary to identify and verify a customer.

The identification and verification methods, and the necessary documents to be obtained from customers, are specified in the relevant ordinance of the APTCP. Previously, face-to-face know your customer (KYC) procedures through the presentation of identification documents and non-face-to-face KYC procedures through postal mail with no-forwarding service were used in practice. However, since 30 November 2018, online-based procedures involving the provision of a photo or video of customer identification documents are permitted as a new KYC method. As mail-based procedures result in delays before financial institutions and their customers can enter into transactions, this new method will help financial institutions to conduct their KYC procedures more rapidly.

In addition, financial institutions must check, inter alia, their customers’ knowledge, investment experience, risk appetite, investment purpose and asset portfolio, and ensure that the offered products are suitable for those customers. In fact, a lot of litigation and alternative dispute resolutions in relation to complex structured products (especially sales of derivative embedded debt securities to retail investors without suitability checks or adequate explanations) have occurred in Japan during the past decade. Such suitability checks are necessary to mitigate post-sale liability of distributors.


In Japan, most structured products are not listed on exchanges and are traded via securities companies as OTC transactions. The trade volume of such OTC structured products in the secondary market is relatively low.

The only category of listed structured products on Japanese exchanges is exchange-traded notes (ETNs) that intend to track the performance of various underlying indices. In 2011, the listing rules of the Tokyo Stock Exchange (TSE) for ETNs were established, and trades of listed ETNs on the TSE began. As of August 2019, approximately 20 ETNs were listed on


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the TSE, all of them issued by non-Japanese issuers. In accordance with the practice in the Japanese market, these ETNs are in the form of Japanese depositary receipts issued pursuant to the Trust Act, and their underlying assets are derivative embedded notes governed by non-Japanese laws.


i Taxation for Japanese investors

Typical structured products in the form of debt securities are generally treated as bonds for Japanese tax purposes. Any interest on bonds and gains derived from the sale or redemption of bonds that are receivable by individual residents of Japan and Japanese corporations are generally subject to Japanese taxation, as is the case with straight bonds.

For individual residents of Japan, taxable income in relation to bonds is taxed separately from other types of income, such as business income and salary income. The applicable tax rate is, in general, 20.315 per cent (including a 5 per cent local tax and 0.315 per cent special surtaxes). When an issuer or a paying agent located in Japan makes a payment of interest on bonds, 20.315 per cent of the interest amount is withheld. Proceeds from a sale of bonds and payment of principal (except the principal of certain discounted bonds and strip bonds) are not subject to withholding tax, so in general individual residents of Japan must file a tax return with the relevant regional taxation office with respect to gains derived from a sale or redemption of bonds.

For Japanese corporations, all income and losses are aggregated for the purpose of corporate taxation. Applicable tax rates are slightly different depending on the amount of capital and location, but the effective tax rate for Japanese corporations is approximately 29.74 per cent. However, a 15.315 per cent withholding tax is withheld on the payment of interest made by an issuer or a paying agent located in Japan.

Interest on structured deposits is also taxed and withheld at the same rate for interest on bonds.

ii Tax ruling

There is no official tax clearance or ruling system from the National Tax Agency, the tax authority in Japan. However, when taxation issues arise during a structuring process and no clear interpretation has been revealed by the authority, issuers or arrangers of structured products may submit an enquiry before a transaction to request a written response from the National Tax Agency about whether they will be subject to taxes. This advance enquiry functions in practice as a tax clearance in other countries. In addition, issuers and arrangers can also obtain informal guidance on the tax treatment of a particular transaction through informal consultation with tax officers at regional taxation bureaus or tax offices. This informal guidance may provide some comfort to proceed with a transaction.

iii Recent amendments to tax legislation

On 1 January 2016, amendments to financial instruments taxation laws became effective in order to reduce the imbalance of income tax treatments on individual residents among various financial instruments. The goal of the amendments is to achieve simpler taxation and encourage investments in securities by individual investors. The amendments enable losses on the sale of listed equity securities or publicly offered bonds to be deducted against interest on publicly offered bonds and gains derived from the sale or redemption of publicly


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offered bonds, and at the same time enable losses on the sale of non-listed equity securities or privately offered bonds to be deducted against interest on privately offered bonds and gains derived from the sale or redemption of privately offered bonds.

VI OTHER ISSUES

i Regulations of the self‑regulatory body

In relation to complex products similar to OTC derivatives transactions, the Japan Securities Dealers Association (JSDA), a self-regulatory body of brokers and dealers in Japan, introduced self-regulatory regulations in April 2011 that apply to members of the JSDA.

The regulations require that: a before distributing products to customers, members verify reasonable grounds

concerning the suitability of products, such as risk profiles and performance, and establish solicitation criteria for selecting customers by considering their age, whether they have previous experience with the type of transaction and the assets that the customers hold; and

b members enhance their obligations to explain when soliciting and selling products by: • delivering explanatory documents, including warnings of risks inherent in

products, and the contact information for the institution for financial alternative dispute resolutions;

• providing explanations about material matters such as losses in worst-case scenarios, selling restrictions and preliminary calculations of the selling amounts during the term of a transaction; and

• receiving confirmation letters from customers.

The JSDA explains that in general, the regulations cover exchangeable bonds, equity indices-linked notes and dual currency bonds with conditions.

ii Impacts of the LIBOR transition

The response in Japan to a potential discontinuation of the London Interbank Offered Rate (LIBOR) involved the establishment of the Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks11 (secretariat: the BoJ) in August 2018. Through practical and robust discussions in and among its three sub-groups (based on loans, bonds and development of term reference rates), relevant proposals were put forth, and the Public Consultation on the Appropriate Choice and Usage of Japanese Yen Interest Rate Benchmarks (Consultation Paper) was published on 2 July 2019.

In Reforming Major Interest Rate Benchmarks,12 the Financial Stability Board advocated a multiple-rate approach under which different appropriate interest rate benchmarks are used depending on the financial instruments or the nature of transactions. This is to be accomplished by enhancing the reliability and robustness of existing interbank offered rates (IBORs), such as the LIBOR and Tokyo Interbank Offered Rate (TIBOR), and identifying a nearly risk-free rate (RFR) that should not reflect the credit risks of banks; the assumption is that IBORs would be used for, inter alia, loans, and RFRs would be used in

11 https://www.boj.or.jp/en/paym/market/jpy_cmte/index.htm/.12 https://www.fsb.org/wp-content/uploads/r_140722.pdf (published in July 2014).


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many derivatives transactions. In Japan, the TIBOR reform was implemented by the JBA TIBOR Administration, and a Tokyo Overnight Average Rate (TONA) was selected to serve as an RFR.

At the time of writing, it is difficult to assess the impact of the transition movement in Japan, but market participants for structured products should monitor the progress of discussions in the market closely.13


As can be seen from the above, the Japanese structured products market is stable and well-developed from many perspectives such as the market’s size, varieties of products, including Japan-specific trust structures, and healthy and enhanced laws and regulations to protect (retail) investors. Market participants from the buy-side as well as the sell-side appear to be very familiar with this asset class. The outlook for the market should be stable, and we believe that market participants can continue to handle new issues such as the LIBOR transition in an appropriate manner going forward.

13 For details about the current Japanese status, see our newsletter entitled ‘Phasing Out LIBOR after 2021: Notes and Legal Considerations Concerning the Cross Industry Committee on Japanese Yen Interest Rate Benchmark’s Public Consultation Paper’: https://www.jurists.co.jp/en/finance-law_190819.html.


41

Chapter 5

SWITZERLAND

Dominique Lecocq and Lucile Cesareo-Hostettler1

I OVERVIEW

The turnover of structured products issued or distributed by major financial institutions negotiated on the national and international markets amounts to 82 billion Swiss francs, and there are currently around 12,000 structured products in Switzerland tradable at SIX Swiss Exchange. This exceptional diversity makes it difficult for investors to compare products, which can lead to inappropriate investments due to misinformation.

Following the entry into force of the EU Prospectus Directive, MiFID II and PRIIPs regulations, and to harmonise the Swiss regulatory landscape with international standards, including OECD guidelines, Switzerland is currently in the process of revising its entire financial regulatory regulation. The Upper Chamber of the Swiss Federal Assembly approved, as a plenum in its 2016 winter session, draft acts for the Financial Services Act (FinSA) and the Financial Institution Act (FinIA). FinSA contains rules of conduct that financial service providers must observe with respect to their clients, including in respect of structured products. FinIA standardises the authorisations for financial service providers, including securities and issuing houses.

On 1 January 2020, both acts (New Regulation) will enter into force. Thus, we primarily analyse structured products in Switzerland under the New Regulation in this chapter.

Switzerland has so far been a playground with a light financial regulation of certain financial sectors such as asset management and advisory services, the distribution of products (with the exception of funds, which are over-regulated) and foreign advisers. There is currently no clear obligation to inquire about a client’s knowledge and experience before entering into a transaction or to warn them of the risks arising from an inappropriate transaction. The New Regulation will address most of these concerns and codify some of the existing practice.

Unlike investment funds, structured products are not subject to a regulatory licence upon issuance: it is securities/issuing houses that are subject to regulatory approval and supervision. Disclosure rules are newly defined in the New Regulation. A distributor of structured products will be subject to a new requirement of being listed in an advisers register under the New Regulation. Foreign distributors will also need to register.

The Swiss regulatory system around structured products is further developed in this chapter.

1 Dominique Lecocq is the managing partner and Lucile Cesareo-Hostettler is an associate at lecocqassociate.


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Financial market supervision is carried out by the Swiss Financial Market Supervisory Authority (FINMA), which is structured as an independent, self-organised public law institution with its own legal personality.2 FINMA’s role is therefore to supervise and monitor the proper application of the financial legislation, which aims at protecting creditors, investors and insured persons as well as ensuring the proper functioning of the financial market.3

Hence, FINMA supervises and carries out enforcement proceedings. It has jurisdiction to impose criminal sanctions when provided by law.4 Moreover, FINMA’s mandate includes granting practice authorisations to the following financial institutions:a banks; b securities dealers (which will be renamed securities firms under FinSA); c insurance companies; d fund management companies; e custodian banks; f asset managers of collective investment schemes (funds); and g representatives of foreign collective investment schemes (funds).

These entities and actors will then be subject to ongoing prudential supervision by FINMA.5 Until the entry into force of the New Regulation on 1 January 2020, structured products

are governed by the Swiss Collective Investment Schemes Act of 23 June 2006 (CISA), which has already been subject to several legislative modifications since that date. They are not per se submitted to the requirements applicable to collective investment schemes,6 even if there are many similarities between the two financial instruments.7 The only provision of CISA dealing with structured products is Section 5 CISA.8

In Switzerland, as in many other jurisdictions, structured products have been in the spotlight for several years. Following the 2008 financial crisis and the bankruptcy of the Lehman group, FINMA conducted a large-scale investigation into the distribution to retail clients in Switzerland of structured products that were guaranteed by the subsidiaries of Lehman Brothers Holdings Inc.9 Indeed, the fall of the Lehman group had significant repercussions on the Swiss financial centre. In particular, many retail investors had invested in products with guaranteed capital, and thus had suffered a substantial risk exposure with the insolvency of the Lehman group.10

2 Section 5 of the Federal Act on the Swiss Financial Market Supervisory Authority. 3 Section 4 FMSA.4 Section 50(1) FMSA.5 https://www.finma.ch/en/finma/activities/authorisation-licensing/.6 According to Section 5(4) CISA, in all other respects, structured products are not governed by this Act.7 Beguin, Nicolas/Richa, Alexandre, Le mandat de gestion de fortune, 2e Ed, Zurich, 2017, p. 2 and Gomez

Richa, Lucia, Les produits structurés et la protection de l’investisseur, Zurich, 2015 p. 127.8 Section 5 CISA and Chapelain de la Villeguerin, Donatienne/Mentha, Yves, ‘La distribution de fonds de

placements et de produits structurés in Services financiers: Suisse et Union européenne’, DDE – Dossiers de Droit Européen Band, No. 31, Ed Kaddous, Christine/Matthey, Sylvain, Zurich, 2016, p. 124.

9 FINMA Report of 2 March 2010, Madoff Deal and Distribution of Lehman Products: Impact on Investment Advisory and Wealth Management Activities (FINMA report of 2 March 2010), p. 4/21.

10 FINMA report of 2 March 2010, p. 14/21.


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At that time, structured products were considered a fashionable alternative to collective investments schemes. Even if the risk exposure was generally known, the probability of a failure of the reputable issuers was low rated.11 One thing led to another, and many banks were presenting structured products, including structured products with guaranteed capital, as prudent investments.12

Investigations revealed the existence of a big deficiency in the law: the former Swiss Federal Act on Collective Investment Schemes, in force at the time, provided that a simplified prospectus was to be made available at the issuance of a structured product in the secondary market phase.13 In the case of Lehman, however, the great majority of subscriptions took place on the primary market, between the publication of the offer and the issuance (i.e., at a moment when a prospectus was not yet required under the law).14

Based on these findings, FINMA concluded that, even if structured products with guaranteed capital were, as such, adapted to retail clients, the regulations of the time, and in particular those regarding investor protection provisions, were totally ineffective.15 Following FINMA’s recommendations, the revised CISA, including the Section 5 that is currently found in the law, entered into force on 31 March 2013.16

Despite these legislative changes in 2013, the overall financial regulations in Switzerland, including the law on structured products, are still considered to be inconsistent and incomplete, particularly with regard to behavioural rules and financial products regulation.17 The Swiss obligations applicable to financial product prospectuses are very divergent and incomplete, and the information contained in prospectuses is often too detailed and not clear enough for customers.18

In respect of the above, the aim of the legislator when adopting FinSA was to provide a clear and comprehensible framework for investors through imposing disclosure requirements on financial service providers.


Structured products are listed in the definition clause of FinSA under the definition of financial instruments, as are shares, collective investment schemes, units and debt securities.19 However, FinSA does not precisely define structured products. The law only lists capital-protected products, capped return products and certificates as examples of what could be considered structured products.20

Section 94 (3)(a) of the Financial Market Infrastructure Act (FMIA) provides that structured products such as capital-protected products, capped return products and certificates are not considered to be derivatives in accordance with Sections 93 to 117 FMIA.

11 FINMA report of 2 March 2010, p. 15/21.12 FINMA report of 2 March 2010, p. 15/21.13 Official Compilation of Federal Legislation (RO) 2013 585, p. 587.14 FINMA report of 2 March 2010, p.18-19/21.15 FINMA report of 2 March 2010, p. 3/21.16 RO 2013 585, p. 603.17 Message from the Federal Council on the Financial Services Law and the Financial Institutions Act of

4 November 2015, (Message), p. 8,112.18 Message, p. 8,112.19 Section 3 (a)(4) FinSA.20 Section 3 (a)(4) FinSA.


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The wording of Section 94 (3)(a) FMIA is based on that of Section 5(1) CISA, which is rather vague and does not provide a real criterion for distinguishing structured products from derivatives. Thus, there is still no legal definition of structured products, and it is still possible to refer to the practice developed in the context of Section 5 CISA to determine whether an instrument is a structured product.

It is generally accepted that a structured product is a forward financial instrument that incorporates or combines several financial instruments, generally a derivative, and whose maturity value varies according to one or more underlying assets.21 Another proposal is to define a structured product as ‘a securitised derivative instrument . . . of varying complexity and [that] incorporates one or more claims against the issuer’.22 They can be listed or unlisted.23

i Issuance and distribution

General conditions for distribution to retail clients

The current provisions in force under Section 5 CISA with regard to the issuance and distribution of structured products are included in FinSA with only a few terminological adaptations.24

In substance, according to Section 70 FinSA, structured products can only be distributed in Switzerland or from Switzerland to retail clients without a long-term asset management or investment advisory relationship if:a they are issued by a regulated financial institution such as a bank, an insurance company

or a securities house (actual securities dealer), or by a foreign institution that is subject to equivalent standards of supervision;25 or

b if they are not issued by a regulated financial institution (as mentioned above in (a)), they are guaranteed or secured in an equivalent manner by it.26

Thus, where an issuer is not a regulated financial institution, equivalent guarantees or securities in the form of contractual commitments or rights of pledge must be provided. The Financial Services Ordinance project (FinSO) shall contain a definition, although not yet finalised, of ‘guaranteed or secured in an equivalent manner’, which shall be as follows: any legally enforceable guarantee by which a supervised financial institution referred to in Section 70(1) FinSA undertakes to meet the commitments of the issuer in terms of services, and provide the issuer with financial resources;27 and the provision of a security interest that is legally enforceable in favour of the investor.28

Under FinSA retail clients are defined as non-professional clients29 (see below for a definition of professional clients). The definition of retail clients also covers high-net-worth clients defined as whoever validly declares to have the necessary knowledge to understand

21 Beguin, Nicolas/Richa, Alexandre, Le mandat de gestion de fortune, Zurich, 2017, p. 25, Gomez Richa, Lucia, Les produits structurés et la protection de l’investisseur, Zurich, 2015, p. 23 and noted references.

22 Gomez Richa, Lucia, Les produits structurés et la protection de l’investisseur, Zurich, 2015, p. 88.23 Beguin, Nicolas/Richa, Alexandre, Le mandat de gestion de fortune, Zurich, 2017, p. 25.24 Messages, p. 8192.25 Section 70(1) FinSA.26 Section 70(1) FinSA.27 Section 96(3)(a) FinSO. 28 Section 96(3)(b) FinSO.29 Section 4(2) FinSA.


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the risks inherent in investments because of his or her personal education and professional experience, or because of comparable experience in the financial sector and wealth of at least 500,000 Swiss francs;30 or holding a fortune of at least 2 million Swiss francs.31

Moreover, FinSA also provides opt-in options for professional clients. Professional clients who are not institutional clients (see below) can declare that they wish to be considered as retail clients32 and thus be protected by Section 70 FinSA.

If an issuer is a special purpose vehicle, the distribution must be made by a regulated financial institution or a financial intermediary in addition to the guarantees mentioned above.33

Finally, FinSO shall provide that there is an established long-term asset management or investment advisory relationship, in particular if it is concluded for an unlimited number of transactions, and in writing or in any other form of proof by means of a text.34 In this case, the distribution of structured products is possible irrespective of the conditions of Section 70 FinSA.35

General conditions for distribution to professional and institutional clients

There is no specific legal provision in the New Regulation for the distribution of structured products to professional clients and institutional clients as seen above. Section 70 FinSA only applies when structured products are distributed to retail clients. Thus, we deduce that the principles developed under the authority of Section 5 CISA remain applicable: the exclusion of the need to protect retail clients also excludes the need for regulation.36

Professional clients are:a financial intermediaries according to the Swiss Banking Act (BA),37 or under FinIA or

CISA; b insurance companies; c foreign clients subject to prudential supervision (such as defined under (a) and (b)); d central banks; e public law institutions with a professional treasury;f pension funds or institutions for occupational pension provision with a professional

treasury; g companies with a professional treasury; h large companies; and i private investment vehicles with a professional cash position established for high-net-

worth clients.

30 Section 5(2)(a) FinSA.31 Section 5(2)(b) FinSA.32 Section 5(5) FinSA.33 Section 5(1-bis) CISA and Gomez Richa, Lucia, Les produits structurés et la protection de l’investisseur,

Zurich 2015, p. 104.34 Section 96(1) FinSO. 35 Message, p. 8,192 and BSK KAG-bishof/Lamprecht/Schwob /in, Art. 5 No. 23.36 BSK KAG-bishof/Lamprecht/Schwob /in, Art. 5 No. 23.37 Swiss Banking Act of 8 November 1934.


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Moreover, FinSA also provides opt-out options for high-net-worth clients, who can declare that they wish to be considered as professional clients instead of retail clients38 (according to the above) and thus avoid the protection of Section 70 FinSA.

On their side, institutional clients are: a clients who are financial intermediaries according to the BA, or under FinIA or CISA; b insurance companies; c foreign clients subject to prudential supervision (such as defined under (a) and (b));d central banks (which are also professional clients); ande national and supranational public law institutions with a professional treasury.39

Accordingly, we deduce that as under the authority of Section 5 CISA, structured products distributed to professional clients or institutional clients are not required to be issued or guaranteed by a regulated financial institution.40 Of course, specific provisions relating to listing procedures remain applicable (see Section IV.ii).

Advisers register

The issuance of structured products is not per se subject to FINMA’s authorisation and supervision. In most cases, it is the issuer that will be required to be licensed. This will not change under the New Regulation.

The concept of distribution will be integrated into the definition of advisory services under the New Regulation. Client advisers of Swiss financial service providers (and client advisers of foreign financial service providers) that operate in Switzerland will now have to register, personally, in the official advisers register.41 This will be performed by a registration body approved by FINMA.42 Consequently, each client adviser of Swiss and foreign distributors of structured products will have to register themselves.

Registration may be carried out only if the following conditions are met:a the client advisers are sufficiently familiar with the rules of conduct set out by FinSA

and have the necessary technical knowledge to perform their activity;43

b they have concluded professional liability insurance or provide equivalent financial guarantees;44

c they are affiliated with a mediation body in charge of handling disputes between clients and service providers;45 and

d they have not been subject to a criminal sanction or a prohibition on practising.46

It shall be noted that registration of advisers is one of the major innovations of the FinSA regime.

38 Section 5(1) FinSA.39 Section 4(3) and (4) FinSA. 40 Section 70 FinSA.41 Section 28(1) FinSA.42 Section 31(1) FinSA.43 Section 29(1)(a) and Section 6 FinSA.44 Section 29(1)(b) and FinSA. 45 Section 29(1)(c) and Section 74 FinSA.46 Section 29(2)(a) and (b) FinSA.


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Investors’ protection, information and prospectus

FinSA imposes on structured product distributors and advisers, as well as on all financial service providers,47 a general obligation of disclosure in respect of themselves and their activity and proposed financial services.48 This general obligation is completed through the key information document (KID), the prospectus and the performance in some cases of an appropriateness and suitability test.

Rules vary depending on whether the offering is made to retail clients, or to institutional or professional clients.

KIDThe distribution of a structured product to retail clients requires the issuance of a KID that is provided free of charge to clients.49 The KID is a short, easy-to-read document that a retail client can easily understand. It shall include essential guidelines for investors to make a sound investment decision and compare various financial instruments.50 In particular, it should include:a the name of the financial instrument and the identity of the producer; b the type and characteristics of the financial instrument;c the risk and return profile of the financial instrument, with mention of the maximum

loss; d the costs of the financial instrument; e the minimum holding period and the negotiability of the financial instrument; and f information on authorisations and approvals related to the instrument’s financials.51

The KID is especially intended for retail clients. Distribution of structured products to professional clients and institutional clients does not require the provision of a KID.52

Prospectus The provisions in FinSA to issue a prospectus will replace the existing simplified prospectus for structured products, which is impractical. The prospectus requirement under FinSA applies to all equity and debt securities, including derivatives, structured products, bonds and shares, which are offered to the public (except where the law provides for an exemption).53

The prospectus shall contain all information on the issuer, the guarantor and the securities to enable investors to make an investment decision in full knowledge of the situation and risks.54 FinSO provides minimum indications that a prospectus must contain: a all the information on the issuer or guarantor, in particular:

• a presentation of the main risks related to the issuer;

47 Under FinSA, financial service providers are persons who provide financial services in a professional capacity in Switzerland or to clients in Switzerland, and are therefore considered to professionally carry out any independent economic activity in order to obtain a regular income (Section 3 (d) FinSA).

48 Section 8(1) and (2) FinSA.49 Section 8(3) FinSA and Message, p. 8,123.50 Section 60(1) FinSA.51 Section 60(2) FinSA. 52 Section 58(1) FinSA. 53 Message, p. 8,169.54 Message, p. 8,172.


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• a presentation of the board of directors, management, review body and other bodies; and

• the last half-year or annual accounts or, when neither of these is available, indications on asset values and commitments, perspectives, principal disputes, capital structure and voting rights;

b information on transferable securities offered to the public or intended to be traded on a platform, in particular, identification number (ISIN), legal basis, type of issuance, number, type of securities, nominal value, rights and obligations, pricing history and risks to investors related to these transferable securities; and

c all information on the offer.55

Unlike the KID, the prospectus contains a lot of information, which can significantly hinder the level of clarity and understanding for investors. For this reason, it also includes a summary that, in a condensed form and easily understandable language, contains the essential information.56

The prospectus is mandatory and applies in addition to the KID when an investor is a retail client. However, a prospectus is not required if the investor is a professional client or an institutional client.

Appropriateness and suitability test In addition to the general disclosure obligation, KID and prospectus, financial service providers providing investment advisory or wealth management services must verify the appropriateness or suitability of their financial instruments for investors,57 except in the case of an execution-only transaction (if a financial service provider is solely responsible for the execution or transmission of a client’s orders) or a reverse-solicitation transaction (if orders are instigated by the client).58

In principle, the provisions with respect to the appropriateness and suitability tests also apply to professional and institutional clients. However, according to the knowledge and experience of professional and institutional clients, a financial service provider shall proceed to the test only if he or she has doubts about the understanding of the transaction.59

ii Post‑sale responsibility

An important development under the New Regulation is a provision regarding civil liability and accountability for information contained in prospectuses and KIDs, which was not the case under Section 5 CISA (at least not in a clear manner).60 According to the new regime, if inaccurate, misleading or non-compliant information is presented or disseminated by means of a prospectus, KID or similar communication, any person who has participated in the presentation or dissemination of such indications shall be liable for the damage suffered by an investor if he or she fails to prove that he or she has acted with the necessary due diligence.61

55 Message, p. 8,172.56 Message, p. 8,173 and Section 43 FinSA. 57 Section 10 FinSA.58 Section 13 (1) FinSA.59 Message, p. 8,158.60 Gomez Richa, Lucia, Les produits structurés et la protection de l’investisseur, Zurich 2015, p. 261.61 Section 69 (1) FinSA.


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Moreover, FinSA contains criminal provisions in the event of non-compliance.62 In addition, a fine of up to 500,000 Swiss francs shall be imposed on any person who intentionally offers structured products to private clients without complying with the conditions set out in Section 70 FinSA.


Most structured products issued in Switzerland bear an ISIN code, but are generally not listed on a regulated exchange for secondary trading purposes. The first instruments labelled as structured products were listed on the SWX Swiss Exchange Ltd in 1997. Since 2014, SIX Structured Products Exchange Ltd has been operating as an exchange for the Swiss market for the trading of structured products. SIX Swiss Exchange Ltd remains responsible for the admission to listing of structured products.63

Structured products are excluded from the definition of derivatives under FMIA. However, for listing purposes, structured products are assimilated to derivatives on the SIX Swiss Exchange Ltd.64 Thus, in this chapter we do not distinguish between structured products and derivatives in the context of stock exchange listing.

The listing of derivatives is divided into three product groups:65 capital-protection products, yield-enhancement products and participation products.

These three groups of products are broken further down into individual product types in accordance with the classification model of the Swiss Structured Products Association (SSPA).66

There are currently around 12,000 structured products in Switzerland tradable on the SIX Structured Products Exchange Ltd. To facilitate an investor’s decision to choose an appropriate product from among the wide diversity offered and to gain a proper overview of the market, the SIX Structured Products Strategy Indices enable a performance comparison of an individual product with the indexed average in the respective investment category.67

i Legal basis

The FMIA establishes the principle of self-regulation.68 Within this competence, SIX Swiss Exchange is responsible for issuing rules on the admission of securities for trading.

As part of the self-regulation competence, SIX Swiss Exchange has issued rules and regulations on listing securities that must be approved by FINMA.69

62 Title 7 FinSA.63 Gomez Richa Lucia, Les produits structurés et la protection de l’investisseur, Zurich 2015, p. 149.64 Meylan Delphine/Ben Hattar Ariel, ‘Le concept de dérivé dans la LIMF’, GesKR 2018 p. 205 ss, 209.65 SIX Swiss Exchange Ltd, Benchmark for Investment Strategies: SIX Structured Products Strategy Indices,

2019, p. 4 ss.66 SSPA represents, without engaging in commercial activities of its own, the shared interests of the most

important members of the structured products industry: https://www.svsp-verband.ch/en/#. 67 SIX Swiss Exchange Ltd, Benchmark for Investment Strategies: SIX Structured Products Strategy Indices,

2019, p. 2.68 Section 27(1)FMIA. 69 Section 27(1) FMIA.


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In practice, the rules and regulations on listing securities can be divided into several hierarchical levels. At the highest level, we find the Listing Rules and Additional Rules that regulate the listing of securities on SIX Swiss Exchange, followed by the schemes that form an integral part of the Listing Rules and Additional Rules and determine the contents of the listing prospectus.

The other rules and regulations regulate, among other things, the admission to trading on the SIX Swiss Exchange. Directives, circulars and communiqués are supplements to the rules, provide more detailed explanations on their regulatory provisions, explain the practices of the Regulatory Board, and provide details on individual decisions, legal issues in the application of individual provisions of the Listing Rules and changes in practice.70

ii Listing procedure

The listing procedure on SIX Swiss Exchange Ltd is governed by Sections 42 to 48 of the Listing Rules.71

To ensure efficient processing, the listing application must be submitted by a listing agent recognised by the SIX Exchange as being competent to do so.72 The Directive on Recognised Representation regulates both the types of recognition and the recognition procedure.

Various documents must be submitted along with the listing application, including a listing prospectus containing the information required in accordance with the applicable prospectus scheme. Each issuer must also sign a declaration of consent at the time of the initial listing of the securities.73

If an application fulfils the requirements of the Listing Rules, the Regulatory Board will approve it. The Listing Rules set the conditions for maintaining a listing, which include that issuers are required to publish an annual report containing the audited annual financial statements.74

Listing applications are facilitated by CONNEXOR Listing Enhancement, which allows the electronic transmission of requests issuers and their recognised representations.75 Trading may start within one to three trading days after an application is submitted.76 Thanks to the simplified admission process and high data reliability, issuers will realise considerable gains in cost-efficiency.

When a structured product matures, the listing will be automatically terminated by SIX Swiss Exchange without prior notice.77

iii Secondary market

On the secondary market, derivatives are traded either on an exchange or over-the-counter (OTC). In Switzerland, OTC derivatives are not regulated in terms of their characteristics and the structure of the related contracts.

70 The SIX Swiss Exchange rules and regulations are available on its website.71 SIX Exchange Regulation Ltd, Listing Rules, version of 1 July 2019. 72 Section 43 Listing Rules.73 Section 45 Listing Rules.74 Section 49 Listing Rules.75 Sections 1 and 3 of the Directive CONNEXOR Listing Enhancement of 2 May 2019.76 SIX Swiss Exchange’s website.77 Section 39 of the Additional Rules for the Listing of Derivatives.


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The regulated secondary market is the listing on the SIX Structured Products stock exchange or trading platforms of banking institutions.


In Switzerland, three different types of tax apply to structured products: income tax (collected at the cantonal and federal level), withholding tax and stamp duty. The system is extremely complex, as each tax depends on the type of structured product considered. For the purpose of this chapter, we present only a brief overview of the situation.

i Income tax

In general terms, income tax applies to all income of taxpayers, whether one-time or periodic payments.78 This includes returns on movable assets,79 whether in terms of the function of the type of structured product, as periodic interest or as the difference between the purchase and sale price.80

ii Withholding tax

Moreover, Switzerland levies a 35 per cent81 withholding tax on income from movable capital if a debtor is domiciled in Switzerland.82 The withholding tax is then reimbursed under certain conditions based on double taxation treaties or, when the investor is a natural person domiciled in Switzerland, at the end of the taxable benefit period.83

iii Stamp duty

Finally, stamp duty may apply to the issuance and trade of structured products depending on the composition of the underlying derivatives or securities forming the structured product.84 Assessing whether stamp duty applies is a very difficult exercise. In this respect, it is not advisable to self assess a product: SIX Financial Information SA issues information as to the taxability of each product, and a reliance on SIX’s tax indication is accepted and recognised by the tax administration.

If stamp duty applies, the rate is 0.15 per cent (0.075 per cent for each contracting party) if the structured product is considered as a Swiss security, and 0.3 per cent (0.15 per cent for each contracting party) if the structured product is considered a foreign security.85

78 Section 16(1) of the Swiss Federal Direct Tax Act of 14 December 1990 (FDTA). 79 Section 20(1) FDTA.80 Informations fiscales, éditées par la Conférence suisse des impôts CSI, Traitement fiscal des obligations,

produits dérivés et combinés, p. 16 ss.81 Section 13(1)(a) of the Swiss Withholding Tax Act of 13 December 1965 (WTA).82 Section 1(1) and 4 (1)(a) WTA.83 Section 22(1) WTA.84 Section 13(2) of the Swiss Stamp Duty Act (SDA).85 Section 16(1) SDA.


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VI OUTLOOK AND CONCLUSIONS

The New Regulation does not address the current lack of definition of structured product, but codifies the offering process and the disclosure requirements. To date, structured products remain excluded from the definition of derivatives in FMIA, but are nevertheless treated as such when listed on the Swiss Stock Exchange.

The New Regulation will enter into force on 1 January 2020, but the implementing ordinances are not yet finalised. It is possible that additional information will arise from the final draft of the ordinance. We also expect that the Swiss Bankers Association or FINMA will issue an implementing circular during the course of 2020.


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Chapter 6

UNITED STATES

Christopher S Schell, Yan Zhang and Derek Walters1

I OVERVIEW

The structured products market in the United States has undergone tremendous change in the past 10 years since the ending of the global financial crisis. The overall market of new issuances increased to over US$56 billion a year in 2018, with over a 16,000 aggregate number of deals issued on a Securities and Exchange Commission (SEC)-registered basis.2 The product mix has changed and a wider variety of equity-linked products are available today, with many products routinely issued today that were unavailable 10 years ago. Tremendous variation in the manner of issuing structured products now exists in the United States, including large institutional private offerings, SEC-registered retail offerings and offerings of structured certificates of deposits issued by regulated banks. In addition, the distribution model for selling structured products in the United States has undergone arguably the most change. Many existing large wealth management or financial advisory firms have embraced the concept of ‘open architecture’. Whereas in the past, these firms would typically restrict their sales to products issued by their affiliates, now they encourage non-affiliated structured product issuers to use their distribution platforms. Supplementing, and at times competing with, the sale of structured products by these large broker-dealers is an increase in sales of structured products by independent wholesale or intermediate distribution firms, as well independent financial advisers, often acting in a fiduciary capacity for their investor clients. New issuers, primarily financial institutions based in Canada and Europe, have entered the marketplace. Finally, dedicated structured product electronic platforms have been created to allow brokers to access product information, as well as educational materials, and to purchase products, through website portals created for these purposes. The role and rules of the various regulators in the United States tasked with supervising this market has evolved with the market. This chapter addresses the regulatory framework that has been built to address this expanding and changing marketplace.

One of the central tensions for the US regulators grappling with this changing landscape has been between the perspective that the market is benefiting from democratisation versus the view that it is subject to inappropriate ‘retail-isation’. The principal US regulator, the SEC, has made clear that it will not determine the merits of any given structured product

1 Christopher S Schell, Yan Zhang and Derek Walters are partners at Davis Polk & Wardwell LLP. The authors would like to thank their colleague Vidal Vanhoof for his assistance with this chapter. They would also like to thank their colleagues Po Sit, Aliza Slansky and Joseph M Gerstel for their assistance with the tax section of this chapter and Randall D Guynn, Dana E Seesel, Greg Swanson and Sumeet Sanjeev Shroff for their assistance with the bank regulatory section of this chapter.

2 The Prospect News, Structured Products Daily.


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or otherwise proscribe products in light of the view that the continued depth of the US capital markets benefits from new product introductions. This view stems from the bedrock belief that investors should be able to make their own investment decisions, even with complex products, so long as they have full and accurate disclosure with which to make their investment decision. This approach stems from the belief that individual investors can benefit from products that were only available to large institutional investors in the past and thereby democratises the investment landscape. On the other side, regulators are clearly concerned that not all retail investors will benefit from these products, whether they do not have the financial experience necessary to understand the products or whether unscrupulous distributors recommend unsuitable investments to them. From this perspective, the SEC and perhaps even more so the Financial Industry Regulatory Authority, Inc (FINRA), a self-regulatory organisation regulating broker-dealers, have created new rules and regulatory frameworks to police the market for complex products covering a range of issues. While these new rules have not always exclusively targeted structured products, they evince concerns that retail investors need careful protection when facing investment decisions relating to the retail-isation of complex financial instruments. These intertwined regulatory initiatives have addressed a wide variety of issues, including conflicts of interests, fees and commissions, sales to retirees, distribution governance procedures, and supervision and complex product creation and marketing more generally.

The regulatory environment in the United States is made more complex by the fact that structured products are primarily issued by heavily regulated bank holding companies. These banks are subject to a myriad of bank capital, resolution planning and similar regimes that directly affect capital markets transactions, including structured products. For example, the Board of Governors of the Federal Reserve System (Federal Reserve) has formalised rules regarding eligible long-term debt that have had a major impact on structured products, and which types of entities can issue them, as described in this chapter.

Two primary themes underlie the current regulatory regime for structured products. The first is the clear message from the regulators that providing clear, accurate product disclosure to investors is not always sufficient. The rules promulgated by the principal regulators focus on appropriate governance of the product creation process and sufficient oversight of the sales process, even to the extent where the product issuer must, in some circumstances, take certain actions to monitor and assess the sales process by independent third-party distributors of the issuer’s products. This focus evinces the regulators’ concerns that certain sales efforts can, in some circumstances, amount to a concerning level of pressure on less financially sophisticated retail investors of products. As such, these regulators have taken the view that the creators and issuers of these products are well placed to understand the benefits and risks of their products and so should act as one of the gatekeepers to ensure they are sold only to suitable investors. The second is that the US regulators have retained the post-financial crisis activism in enforcement. This trend has meant that while a number of landmark enforcement actions occurred in the aftermath of the crisis as the regulators took a more activist approach to enforcement, the enforcement taskforces remain active to this day. Given that this focus has now spanned two different presidential administrations, it is fair to say that it likely reflects a bipartisan approach to the enforcement of the laws and regulations governing complex products sold to individual investors, including structured products.

This chapter explores how these trends manifest themselves in the overall regulatory landscape. It discusses the roles and legal regimes of the various US regulators of structured products from the SEC and FINRA to state law regulators, and specific issues such as the


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sales and marketing rules, Regulation Best Interest, exchange listing issues and the rules governing the use of distributors, such as know your distributor (KYD) requirements. In general, the chapter is organised thematically to address these principal regulatory rules and related concerns raised by regulators. We also cover generally the typical US tax treatment of structured products and other issues that touch upon structured products, such as the upcoming transition away from LIBOR.


i US securities laws and the role of the SEC

Most structured products issued in the US market are issued as securities or certificates of deposit (CDs).

The Securities Act of 1933, as amended (Securities Act) regulates offers and sales of securities in the United States. All offers and sales of securities must be made pursuant to a registration statement, except for certain exempt securities and exempt transactions. Every offering needs to be registered or rely on an exemption from registration: it is the specific offering that is registered, not a series or class of securities. If no exemption is applicable, under the central provision of the Securities Act, Section 5, it is unlawful to offer a security unless a registration statement has been filed as to the security, and it is unlawful to sell a security unless a registration statement is in effect as to the security.

A registration statement is a filing with the SEC that includes a base prospectus, which contains general information about the issuer and the securities being registered. Disclosure about the issuer in its annual, quarterly and other periodic reports is typically incorporated by reference into the base prospectus. The SEC is a government agency that is the primary overseer and regulator of the US securities markets. Its mission is ‘to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation’.3

Registration statements are subject to review by SEC staff, although the SEC states that it ‘does not evaluate the merits of securities offerings, or determine whether the securities offered are “good” investments or appropriate for a particular type of investor’.4 Registration statements become effective upon SEC declaration or, in certain cases, automatically. Filing fees are payable to register securities with the SEC (currently US$129.80 per US$1 million of securities (with effect from 1 October 2019)).

Exemptions from registration include:a Rule 144A: a safe harbour exemption for resales of securities to qualified institutional

buyers (essentially, large institutional investors);b Regulation D: exemptions for sales of securities to accredited investors (which include

certain institutional investors, as well as high-income or high-net-worth individuals);c Regulation S: safe harbours for offers and sales that occur outside the United States;

andd Section 3(a)(2): an exemption for securities issued or guaranteed by a bank or a

regulated US branch or agency of a non-US bank.

3 US Securities and Exchange Commission, ‘What We Do’: https://www.sec.gov/Article/whatwedo.html (accessed 31 July 2019).

4 US Securities and Exchange Commission, ‘Federal Securities Laws’: https://www.sec.gov/page/federal-securities-laws?auHash=B8gdTzu6DrpJNvsGlS1-JY1LnXDZQqS-JgJAgaSXimg (accessed 31 July 2019).


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CDs are issued by banks and insured by the Federal Deposit Insurance Corporation up to applicable limits. Structured CDs always provide for the repayment of the deposit amount at maturity. CDs are generally not securities for the purposes of the Securities Act and, therefore, are not required to be registered thereunder. However, similar risk and disclosure considerations apply. As a result, typical market practice is for the disclosure package about a structured CD to be relatively equivalent to the disclosure package about an SEC-registered security.5

US securities laws generally impose liability for material misstatements and omissions in the offering documents. The applicable standard, persons subject to liability and potential defences depend in part on whether the securities are SEC-registered.

The typical disclosures provided to investors in SEC-registered structured product offerings can be divided into three broad categories:a Disclosure about the issuer: typically, structured products are issued or guaranteed by

an entity that is subject to extensive ongoing reporting requirements. Those disclosures, which are made in public filings, are typically incorporated by reference into the base prospectus or similar base offering document (such as the offering memorandum or offering circular).

b Disclosure about the structure and related adjustment mechanics: these disclosures are typically contained in one or more of the offering documents that supplement the base offering document (such as a prospectus supplement or product supplement or the preliminary and final pricing supplements).

c Disclosure about the underlying reference asset or assets. These disclosures are typically contained in one of the offering documents that supplements the base offering documents (such as an underlying supplement or the preliminary and final pricing supplements). However, under a 1996 no-action letter, the SEC staff has granted relief to issuers of securities linked to equity securities issued by another (unaffiliated) issuer (underlying company) if the issuer does not have any material non-public information about the underlying company and where there is sufficient market interest in and publicly available information regarding the underlying company. In this case, the issuer may refer investors to disclosures made by the underlying company without having to take liability for such disclosures. The SEC staff has extended this analysis to exchange-traded funds (ETFs).

ii Broker‑dealer regulation and the role of FINRA

FINRA is a non-governmental self-regulatory organisation that regulates member broker-dealer firms. Most issuers of structured products are affiliated with one or more broker-dealers that are members of FINRA and need to comply with its rules. FINRA has long been focused on structured and complex products and other issues relevant to structured products, such as communications with the public, conflicts of interest, suitability and KYD policies and procedures. Some of FINRA’s key relevant guidance in these areas is summarised in Section III.

5 Typical plain vanilla CDs have very abbreviated disclosure, often limited to the term and interest rate.


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iii State securities laws

Each state has its own securities laws (often referred to as ‘blue sky laws’). These state laws frequently prescribe registration or qualification requirements that apply to securities, including SEC-registered securities, unless such requirements are preempted pursuant to Section 18 of the Securities Act. Because issuers of structured products typically list at least one class of their equity (or debt) securities on a national securities exchange, these state law requirements will be preempted for all of its securities (including structured products) that rank equal or senior to that listed security so long as that listed security remains outstanding and listed.

However, even if the registration and qualification requirements are so preempted, state securities laws may still require notice filings or payment of fees. In addition, state securities regulators retain the ability to bring actions under state laws that, for example, prohibit fraud.

iv Recent bank regulatory issues applicable to structured products

On 15 December 2016, the Federal Reserve released its final rule on total loss-absorbing capacity (TLAC) and eligible long-term debt (LTD) securities (Final Rule). The Final Rule requires the top-tier holding company of each US global systemically important banking organisation (each a covered BHC) to maintain certain minimum amounts of external eligible TLAC (consisting, essentially, of regulatory capital and eligible LTD securities) and external eligible LTD securities.

In addition, according to the clean holding company requirements in the Final Rule, a covered BHC is prohibited from directly incurring certain liabilities, including short-term debt and parent guarantees of subsidiary liabilities with certain impermissible cross-defaults. The clean holding company requirements also impose a cap on unrelated liabilities of a covered BHC at 5 per cent of its external TLAC. Unrelated liabilities generally include, among other non-contingent liabilities, any LTD securities issued by a covered BHC to third parties that are excluded from eligible LTD securities. Importantly, structured notes are excluded from eligible LTD securities. As a result, they do not count toward a covered BHC’s minimum external TLAC or LTD requirements and instead are treated as unrelated liabilities that are subject to the 5 per cent cap.

The Final Rule defines structured note as a debt instrument that:

(1) Has a principal amount, redemption amount, or stated maturity that is subject to reduction based on the performance of any asset, entity, index, or embedded derivative or similar embedded feature;(2) Has an embedded derivative or similar embedded feature that is linked to one or more equity securities, commodities, assets, or entities;(3) Does not specify a minimum principal amount that becomes due upon acceleration or early termination; or(4) Is not classified as debt under GAAP,provided that an instrument is not a structured note solely because it is one or both of the following:(i) An instrument that is not denominated in U.S. dollars; or(ii) An instrument where interest payments are based on an interest rate index.

This definition clearly includes, for example, structured notes where the payment at maturity is based on the performance of one or more equities, commodities or other assets. In other cases, the analysis may be more complex and will depend heavily on the specific structure.


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Another area of bank regulation that has affected structured products has been the QFC Stay Rules. These Rules were designed to improve the resolvability and resilience of US global systemically important banking organisations (G-SIBs), including their subsidiaries and branches worldwide, and the US subsidiaries, US branches and US agencies of foreign G-SIBs (covered entities), by mitigating the risk of destabilising closeouts of qualified financial contracts (QFCs) in the event of a covered entity’s entry into insolvency or resolution proceedings. QFCs include derivatives, repos, securities lending agreements, and contracts for the purchase and sale of a security, among other contracts. The definition of QFC can pick up structured products in certain instances.

The QFC Stay Rules only apply to ‘in-scope’ QFCs: that is, QFCs that expressly include a default right6 against a covered entity or expressly restrict the transfer of the QFC (or any interest in or under or any property securing the QFC) from a covered entity. The QFC Stay Rules include two substantive requirements:a a requirement that an in-scope QFC expressly recognises the FDIC’s power to stay

the exercise of certain default rights and transfer the QFC under the Federal Deposit Insurance Act and Title II of the Dodd-Frank Act (Express Recognition Requirement); and

b a requirement to expressly override certain cross-default rights against a covered entity and provisions restricting the transfer of an affiliate credit enhancement upon an affiliate of the covered entity party entering any insolvency or resolution proceedings (Override Requirement).

While structured products were not the focus of these rules, the rules were drafted such that structured products were captured in certain cases. Issuers were required to review carefully their structured product portfolio to determine whether they included QFCs and, if so, whether any of the QFCs included provisions bringing them in scope for the rules.

The QFC Stay Rules also include a number of exemptions: for example, certain in-scope QFCs governed by US law, and where all non-covered entity parties are US entities are exempted from the Express Recognition Requirement. In-scope QFCs that do not include cross-default rights against a covered entity and that do not restrict the transfer of an affiliate credit enhancement are exempted from the Override Requirement. Even if a structured product is an in-scope QFC, it has to be further analysed to determine whether an exemption is available, depending upon the specific terms of and parties to each agreement.

These rules are another example of the complex interplay between bank regulatory regimes and the sophisticated capital markets transactions that financial institutions perform.

v The enforcement environment

Structured products, especially those offered and sold to retail investors, have faced and will continue to face a very high level of regulatory and media scrutiny in the United States. This includes scrutiny in the form of enforcement actions by the SEC and FINRA.

The SEC is committed to policing all parts of the US capital markets and periodically reviews filings related to offerings of structured products. In recent years, it has brought a

6 The QFC Stay Rules define default right extremely broadly to include, among other things, a right of a party under an agreement to liquidate, terminate, cancel, rescind or accelerate an agreement or transactions thereunder, set off or net amounts owed, exercise remedies in respect of collateral or other credit support, demand payment or delivery, or suspend, delay or defer payment or performance thereunder.


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number of enforcement actions related to structured products with a focus on both sales practice and disclosure issues. The SEC’s Enforcement Division has a special Complex Financial Instruments Unit, which includes former industry participants.

One relatively recent example of an enforcement action involving the Complex Financial Instruments Unit concerned information about potential offerings (essentially, the embedded options from the investor’s perspective) being shared between a structuring desk and potential issuers, but not included in internal education materials for financial advisers. The SEC found that the relevant supervisory policies and procedures were not reasonably designed and implemented to provide effective oversight of the training, education and recommendations of the registered representatives to prevent and detect violations of the Securities Act. This action has led market participants to focus even more heavily on whether, where information about structuring an offering (such as how the underlying reference asset is selected) is shared internally between business units or with issuers, that same information should be included in training materials prepared for financial advisers (and, potentially, shared with investors through the disclosure).

Other cases have concerned failures to adequately disclose hedging and embedded index fees that could negatively impact the value of an underlying index. These cases have further highlighted the importance of clear disclosure regarding trading strategies that underlie indices, as well as the importance of clear disclosure that sets out all of the costs and fees included in indices, including the effect of such costs and fees.

FINRA has also focused much of its recent attention on sales practice risks. Its 2019 Risk Monitoring and Examination Priorities Letter, which identifies topics that FINRA will focus on, addressed suitability, as well as protecting senior investors from fraud, sales practice abuses and financial exploitation.

The US regulators’ focus on enforcement spans changes in administrations, and so is likely bipartisan.

vi The impact of international law and regulation

Outside of laws and regulations governing securities offerings generally, the main area where international developments have affected offerings of structured products in the United States has been in the sphere of benchmarks regulation. In 2013, the International Organization of Securities Commissions published its Principles for Financial Benchmarks: Final Report (Principles), which seek ‘to create an overarching framework of Principles for Benchmarks used in financial markets’7 covering governance and accountability, as well as the quality and transparency of benchmark design and methodologies. Under the Principles, the term benchmark is defined very broadly and includes, among other things, the types of indices often used as underlying reference assets for structured products. While the Principles are not binding, they have been highly influential. As a governance matter and in light of market expectations, many administrators of these types of indices (including proprietary indices) have undertaken audits and published public attestations or compliance statements disclosing the extent of their compliance with the Principles.

In relation to this, the EU Benchmarks Regulation (BMR) has established an EU regulatory framework for benchmarks, including requirements related to benchmark integrity and reliability, transparency and consumer protection, and the authorisation,

7 International Organization of Securities Commissions, ‘Principles for Financial Benchmarks: Final Report’: https://www.iosco.org/library/pubdocs/pdf/IOSCOPD415.pdf (accessed 31 July 2019).


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registration and supervision of administrators. As is the case under the Principles, the term benchmark under the BMR is defined very broadly. In addition to imposing requirements on EU benchmark administrators, the BMR imposes requirements on third-country (i.e., non-EU) administrators by providing that, from January 2022, EU financial institutions will only be able to use a benchmark produced by a third-country administrator (such as a US administrator) in the EU if:a the European Commission has adopted an equivalence decision recognising the

regulatory framework in the applicable third country as equivalent to the requirements of the BMR;

b the third-country administrator is recognised under the BMR; or c the benchmark has been endorsed by an EU financial institution.

As a result, US entities that create indices that will be used on a global basis (e.g., as an underlying reference asset for structured products sold to investors in the EU) have had to consider the requirements of the BMR in creating these indices, in addition to having to engage with regulators in the EU (e.g., in seeking recognition) so that these indices may be used beyond 2021.


i Offerings and distribution

The key players in the structured product markets include issuers who design and issue the structured products and distributors who market and sell the structured products to end investors. Issuers may distribute structured products through their affiliated broker-dealers or financial advisers or through third-party distribution channels, including private banks, retail distributors and independent asset managers.

A number of web-based multi-issuer distribution platforms, such as SIMON, Halo and Luma, have been launched in recent years to provide an open marketplace for broker-dealers and financial advisers to analyse, trade and monitor structured products for their clients. Some platforms use risk analysis tools and models developed by structured product issuers or other technology providers. These online distribution platforms provide broker-dealers and financial advisers easy access to a broad range of structured products and are expected to simplify how structured products are created, distributed and managed over the entire lifecycle. These online distribution platforms may help issuers further expand the structured products market in the United States.

The SIMON platform is operated by SIMON Markets LLC, headquartered in New York City. SIMON is designed to provide educational contents, analytics and lifecycle management tools to financial advisers to help them serve their clients’ investment needs. Originally developed by Goldman Sachs, it became an independent online platform in December 2018 through equity investments by a group of structured product issuers including Barclays, Credit Suisse, HSBC, JP Morgan and Wells Fargo.8

8 See SIMON Markets LLC, ‘SIMON Expands Structured Investment Platform with Six New Investors’ (press release dated 10 December 2018).


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Like SIMON, the Halo platform was developed to change the way structured products are purchased, accessed and traded.9 Halo runs a competitive auction process for live trades, promoting transparency, price competition and trade execution, and provides independent secondary market liquidity. Halo aims to help both issuers and distributors improve their order management workflow and assist in making back office and product compliance more efficient.

The Luma platform, developed by Zuma Financial Technologies, is a joint venture formed by Navian Capital, Bank of America Merrill Lynch and Morgan Stanley.10 Luma is focused on workflow automation, post-trade position monitoring and comprehensive education, training and compliance management. Luma allows distributors to design and price custom structures across all issuers and track all bids in one place.

ii Sales and marketing

As noted above, FINRA is a self-regulatory organisation dedicated to investor protection and market integrity through regulation of registered broker-dealers. Because most structured products are sold by registered broker-dealers, offerings and sales of these structured notes need to comply with FINRA regulations. In recent years, FINRA and the SEC have been heavily focused on structured products, including sales practice, investor communications and conflicts of interest.

Know your customer and suitability

A key concern raised by the SEC and FINRA was the misselling of structured products by distributors. The purpose of the know your customer and suitability obligations under FINRA Rules 2090 and 2111 is to ensure robust investor protection and promote fair dealing and ethical sales practices.

FINRA Rule 2090 (Know Your Customer) requires firms to use reasonable diligence, in regard to the opening and maintenance of every account, and to know the essential facts concerning every customer.11 The know your customer obligation arises at the beginning of the customer–broker relationship and does not depend on whether the broker-dealer has made a recommendation.

FINRA describes suitability obligations as ‘critical to ensuring investor protection and promoting fair dealings with customers and ethical sales practices’.12 FINRA Rule 2111 (Suitability) requires that a member have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member to ascertain the customer’s investment profile.13 The rule provides that a customer’s investment profile ‘includes, but is not limited to, the customer’s age, other investments, financial

9 See Halo Investing, ‘Halo Investing Raises Series B Funding for Global Expansion of Structured Notes Platform’ (press release dated 6 June 2019).

10 See Luma Financial Technologies, ‘Navian Capital, Bank of America Merrill Lynch and Morgan Stanley Launch Open Architecture Online Platform for Structured Products and Annuities’ (press release dated 31 July 2018).

11 See FINRA Regulatory Notice 11-02.12 Financial Industry Regulatory Authority, Inc, ‘Suitability’: https://www.finra.org/industry/suitability

(accessed 31 July 2019).13 See FINRA Regulatory Notices 12-55, 12-25 and 11-25.


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situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs [and] risk tolerance’, along with other information. FINRA Rule 2111 contemplates three main suitability obligations:a reasonable basis suitability: a broker-dealer must perform reasonable diligence to

understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and determine whether the recommendation is suitable for at least some investors based on that understanding;

b customer-specific suitability: a broker-dealer must have a reasonable basis to believe that a recommendation of a security or investment strategy involving a security or securities is suitable for the particular customer based on the customer’s investment profile;

c quantitative suitability: a broker-dealer who has control over a customer account must have a reasonable basis to believe that a series of recommended securities transactions, taken together, are not excessive. Quantitative suitability was FINRA’s attempt to codify its position against excessive trading.

Investor communications

FINRA Rule 2210 governs investor communications by registered broker-dealers and associated persons. The Rule sets forth requirements for content, approval, review, recordkeeping and filing of communications with FINRA.

FINRA Rule 2210 defines three categories of communications: a retail communication: any written (including electronic) communication that is

distributed or made available to more than 25 retail investors within any 30 calendar-day period. A retail investor is any person other than an institutional investor, regardless of whether the person has an account with the firm;

b correspondence: any written (including electronic) communication distributed or made available to 25 or fewer retail investors within any 30 calendar-day period; and

c institutional communication: any written (including electronic) communication that is distributed or made available only to institutional investors but does not include a firm’s internal communications. Institutional investors include various financial institutions, government entities, FINRA members, registered investment advisers, and a person or entity with assets of at least US$50 million.14

Unless an exclusion applies, retail communications concerning any registered structured products must be filed with FINRA’s Advertising Regulation Department within 10 business days of first use or publication. Prospectuses, preliminary prospectuses, offering circulars, free writing prospectuses and similar documents that have been filed with the SEC or any state and similar offering documents concerning securities offerings that are exempt from SEC and state registration requirements are exempted from the filing requirements.

An appropriately qualified registered principal must approve each retail communication before the earlier of use or filing with FINRA. A broker-dealer must establish appropriate written procedures for the review of institutional communications by an appropriately qualified registered principal.

14 Financial Industry Regulatory Authority, Inc, ‘What and When to File with Advertising Regulation’: https://www.finra.org/rules-guidance/key-topics/advertising-regulation/chart (accessed 10 September 2019).


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In addition, pursuant to FINRA Rule 2210 and related FINRA guidance:a communications must be based on principles of fair dealing and good faith, be fair and

balanced and provide a sound basis for evaluating the facts;b no member may make any false or misleading statement or claim in any communication

or publish, circulate or distribute any communication that the member knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading;

c members must ensure that statements are clear and not misleading within the context in which they are made and that they provide balanced treatment of risks and potential benefits; and

d backtested data (e.g., hypothetical retrospective simulation data for an index) is generally prohibited.

Regulation Best Interest

On 5 June 2019, the SEC adopted Regulation Best Interest, which imposes a new standard of conduct for registered broker-dealers that will enhance the standard of conduct beyond the existing suitability obligations imposed by FINRA regulations.15 The compliance date for Regulation Best Interest is 30 June 2020.

Specifically, Regulation Best Interest requires that a broker-dealer and its associated persons who are natural persons when making a recommendation, including a recommendation of structured products, must act in the retail customer’s best interest and not place its own interests ahead of the customer’s interests. To satisfy this best interest obligation, a broker-dealer must satisfy each and every one of the following four component obligations:a disclosure obligation: a broker-dealer, before or at the time of the recommendation,

must provide the retail customer, in writing, full and fair disclosure of all material facts as to the scope and terms of its relationship with the retail customer and all material facts relating to conflicts of interest that are associated with a recommendation;

b care obligation: a broker-dealer must exercise reasonable diligence, care and skill in making the recommendation. The care obligation is modelled after the concepts of reasonable-basis suitability, customer-specific suitability and quantitative suitability, but under a higher best interest conduct standard than the existing requirements under FINRA regulations;

c conflict of interest obligation: a broker-dealer must establish, maintain and enforce policies and procedures reasonably designed to identify, monitor and mitigate (or eliminate, if possible) conflicts of interest; and

d compliance obligation: a broker-dealer must establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.

The SEC does not define best interest. Instead, whether a broker-dealer has acted in a retail customer’s best interest is based on an objective assessment of the facts and circumstances of how the broker-dealer has satisfied the four component obligations of Regulation Best Interest at the time the recommendation is made. The best interest standard does not

15 See US Securities and Exchange Commission, ‘SEC Adopts Rules and Interpretations to Enhance Protections and Preserve Choice for Retail Investors in Their Relationships With Financial Professionals’ (press release dated 5 June 2019) and SEC release No. 34-86031 dated 5 June 2019.


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necessarily obligate a broker-dealer to recommend the least expensive security or investment strategy, so long as the broker-dealer can show that it satisfies the four component obligations of Regulation Best Interest.

Regulation Best Interest only applies when a broker-dealer makes a recommendation to a retail customer, which is defined as a natural person, or the legal representative of such person, who receives a recommendation for any securities transaction or investment strategy and uses the recommendation primarily for personal, family or household purposes. Unlike the FINRA definition of retail investor, the term retail customer includes only natural persons acting for personal, family or household purposes, regardless of wealth or sophistication. In addition, Regulation Best Interest will not apply when the natural person is represented by professional representatives such as broker-dealers, registered investment advisers or other similar fiduciaries. Therefore, distributors who sell structured products directly to broker-dealers or registered investment advisers, rather than retail customers, will not be subject to Regulation Best Interest.

The SEC explicitly stated that it does not intend for Regulation Best Interest to create a new private right of action. Under certain circumstances, Regulation Best Interest may provide, however, a new basis for investors to bring claims of fraud against broker-dealers. To protect investors, broker-dealers are not permitted to contract out of Regulation Best Interest.

iii New product approval and post‑sale review

Published in October 2013, the stated objective of FINRA’s Report on Conflicts of Interest (Conflicts Report) was to focus on firms’ approaches to identifying and managing conflicts in three critical areas: firms’ enterprise-level frameworks to identify and manage conflicts of interest; approaches to handling conflicts of interest in manufacturing and distributing new financial products; and approaches to compensating their associated persons, particularly those acting as brokers for private clients.

The Conflicts Report specifically addresses broker-dealers’ obligations in identifying and managing conflicts in manufacturing and distributing new structured products. The key practical takeaway from the Conflicts Report for structured products is the need for firms to be on the lookout for situations in which they or one of their affiliates plays a role in connection with an offering that may give rise to potential conflicts, for example, acting as an index sponsor or calculation agent, and consider how to minimise and appropriately disclose any such potential conflict. The Conflicts Report noted a number of effective practices issuers and broker-dealers can adopt to address the conflicts of interest that a new product may present, including using new product review committees to identify and mitigate conflicts and performing post-launch reviews of new products to identify potential problems with a product that may not have been readily apparent during the initial review.

Historically, most issuers of structured products in the United States relied on one or more of their affiliated broker-dealers to distribute their products. More recently, the open architecture model has become more prevalent. Under this model, broker-dealers that are not affiliated with the issuer may distribute the issuer’s products. Among other things, this model allows broker-dealers to offer their clients structured products issued by a number of different issuers, thereby avoiding giving their clients concentrated exposure to the credit risk of one issuer or a small number of issuers. The open architecture model is also particularly important for foreign issuers that may not have a sales force in the United States to assist in distributing their products.


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The Conflicts Report encouraged issuers, as product manufacturers, to take responsibility for how products, particularly complex products, are distributed to investors by implementing effective KYD policies to assess potential distributors’ sales practices, marketing strategies, registered representative training, investor education, compliance culture and customer base. Market participants use KYD policies and procedures to assess potential distributors of structured and complex products, which FINRA says helps ‘mitigate the incentive to increase revenue from product sales by using distribution channels that may not have adequate controls to protect customers’ interests’.16 According to FINRA in the Conflicts Report, effective KYD practices include:a conducting background checks on the distributor and relevant employees;b reviewing the financial soundness of the distributor;c requiring distributors to complete a detailed questionnaire to help the manufacturer

assess a distributor’s sales practices, marketing strategy, registered representative training, investor education, compliance culture, product classification, trade review and sign-off process and distribution strength;

d interviewing a distributor to develop an understanding of the firm’s: • compliance culture; • experience, particularly with more complex products; and • capability and willingness effectively to discharge its suitability obligations;

e obtaining information about a distributor’s customer base;f reviewing a distributor’s relevant compliance manuals, written supervisory procedures

and other relevant materials;g reviewing and approving the distributor through a cross-functional committee;h reviewing sub-distributors and sub-dealers annually; andi requiring distributors and sub-distributors to sign an agreement committing to ensure

adherence to the relevant rules and regulations (such as suitability and due diligence).

FINRA’s guidance with respect to complex products is discussed in Section VI.ii.


i Exchange‑traded notes generally

Exchange-traded notes (ETNs) raise special legal and regulatory considerations in the United States. The term ETNs is commonly used to refer to exchange-listed notes that are linked to an underlying index or asset, offered on a continuous basis and subject to daily or weekly redemption at the investor’s option. These features distinguish notes referred to as ETNs from ordinary debt securities that are listed on an exchange; the latter two features also distinguish ETNs from ordinary structured notes that are listed on an exchange.

ETNs are typically offered on a continuous basis, which means that the issuer or its broker-dealer affiliate continuously stands ready to issue and sell the ETNs to meet market demand. The price at which the issuer or its broker-dealer affiliate would be willing to sell the ETNs is typically based on their indicative value. The indicative value of a series of ETNs is determined in a formulaic manner based on the value of the ETNs’ underlying index or

16 Financial Industry Regulatory Authority, Inc, ‘Report on Conflicts of Interest’: https://www.finra.org/sites/default/files/Industry/p359971.pdf (accessed 31 July 2019).


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asset at the time of determination, and is the amount the issuer would be required to pay on the ETNs if the payment at maturity or upon early redemption were determined at that time. The willingness of the issuer or its broker-dealer affiliate to issue and sell ETNs at their indicative value, combined with the right of an investor to cause the issuer to redeem the ETNs at their indicative value, is expected to ensure (through the creation of arbitrage opportunities) that the trading price of the ETNs on the exchange tracks their indicative value, which the issuer publishes on a real-time basis throughout the trading day. However, the trading price of a series of ETNs on the exchange is determined by supply and demand, and there is no guarantee that their trading price will closely track their indicative value.

ii Disclosure

The unique features of ETNs raise special disclosure considerations. Issuers typically include prominent disclosure about the fact that the indicative value of an ETN is not the same as its trading price on the exchange and that there is no guarantee that an investor will be able to buy or sell the ETNs at their indicative value in the secondary market. Although an investor has the right to cause the issuer to redeem the ETNs at their indicative value, the investor must typically submit at least a specified minimum number of ETNs to exercise that right; an investor owning less than the minimum number must therefore look only to the secondary market for liquidity. ETN prospectuses also typically caution that the issuer may suspend sales of the ETNs at any time, which may cause a premium to develop, and then restart sales, which may cause the premium to collapse.

Market participants sometimes use terminology from the ETF context with respect to ETNs, referring to a new issuance of an ETN as a ‘creation’ and to the indicative value of an ETN as its ‘NAV’. Like ETFs, ETNs offer exposure to an underlying index or asset, with continuous creations and redemptions and the liquidity of an exchange-traded product. Unlike ETFs, however, ETNs do not represent an ownership interest in any underlying assets, but rather are unsecured debt obligations of the issuer. The SEC has advised ETN issuers that their disclosures should avoid using terminology (such as referring to a unit of an ETN as a share) that would suggest that the investor is purchasing an equity interest in an ETF, rather than an unsecured debt security.

iii Leveraged ETNs

Some ETNs offer leveraged exposure to their underlying index or asset. That leverage may be reset daily, monthly or at some other interval. Leveraged ETNs present heightened risks as compared to otherwise similar unleveraged ETNs. Some leveraged ETNs, especially those for which the leverage is reset daily, are not meant to be held for more than one day and may be expected to lose value over time regardless of the directional performance of the underlying index or asset. FINRA has issued a special regulatory notice reminding broker-dealers of their sales practice obligations in connection with leveraged ETNs, including the obligations to ensure that recommendations to customers are suitable and based on a full understanding of the terms and features of the product recommended; that sales materials are fair and accurate; and that adequate supervisory procedures are in place to ensure that these obligations are met. In 2018, the SEC brought an enforcement action against a broker-dealer for unsuitable recommendations of leveraged ETNs that were intended only for short-term trading, but that were sold to investors who incurred significant losses after holding them for an extended period of time.


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iv Regulation M

Common terms and practices with respect to ETNs require relief from certain US regulatory requirements, most saliently Regulation M under the Exchange Act. Regulation M is an anti-manipulation regulation that, subject to certain exemptions, prohibits an issuer, distribution participant and their respective affiliated purchasers from bidding for or purchasing any security that is the subject of a distribution until after the completion of the distribution. ETNs are in continuous distribution and, at the same time, are continuously purchased by the issuer or its broker-dealer affiliate. Absent relief or an available exemption, the purchase of the ETNs at a time when they are in distribution would violate Regulation M.

In 2006 and 2007, the staff of the SEC issued a series of no-action letters advising that it would not recommend enforcement action under Regulation M in connection with the ETNs described in those letters. The principal bases for the staff’s no-action position were the representations of the issuers that the ETNs were redeemable at the option of the holder on a daily or weekly basis and that the secondary market price of the ETNs should not vary substantially from the value of the relevant underlying indices. At the time of listing a new series of ETNs, the issuer is typically required to affirm to the relevant exchange that the new ETNs comply with these no-action letters, which requires the issuer to determine that the ETNs are substantially similar in relevant respects to the ETNs described in the letters.

v Exchange listing rules

To be listed on a US national securities exchange, an ETN must meet the requirements for listing set forth in the rules of the exchange. Many US national securities exchanges have generic listing standards that permit the listing of an ETN so long as those standards are met. The NYSE Arca, for example, has generic listing standards that permit the listing of notes linked to an equity index, commodity or commodity futures, currency, bond index, certain futures or a combination of those underlyings, subject to the satisfaction of certain criteria generally applicable to the issuer of the ETNs and the ETNs themselves, as well as criteria specific to the ETNs’ underlying index or asset.

The NYSE Arca’s generally applicable criteria include requirements that:a the issuer of the ETNs meet certain minimum asset and tangible net worth tests and be

in compliance with certain corporate governance requirements; b the ETNs be redeemable at the option of the holders on at least a weekly basis, or else

have a minimum number of publicly held units, and either have a minimum number of holders or be traded in thousand dollar denominations;

c the ETNs have a minimum principal amount or market value outstanding of US$4 million;

d the ETNs be non-convertible debt securities with a minimum term of one year and a maximum term of 30 years; and

e the ETNs may not provide for a loss or negative payment at maturity that is accelerated by a multiple that exceeds three times the performance of the underlying index or asset.

The NYSE Arca’s underlying-specific criteria vary depending on the type of underlying index or asset. The criteria for an underlying equity index, for example, relate to the concentration of the index in any single issuer, the market capitalisation and trading liquidity of the component stocks and whether the component issuers are domestic or foreign.


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If an ETN does not fall within the generic listing standards of an exchange, the exchange may submit a Rule 19b-4 filing to the SEC, requesting that the SEC approve a new exchange listing rule permitting the listing of the particular ETNs in question.


i General overview

The US taxation of structured products is a grey area built on a skeletal framework of statutes and case law, fleshed out in part by regulations and other regulatory guidance. Although the framework and regulatory authorities establish certain basic principles regarding the treatment of structured products generally, and address the treatment of certain products with a higher level of detail, the Internal Revenue Service (IRS) has not issued tailored guidance on the tax treatment of many of the structured products most commonly offered. Because of the lack of certainty concerning the proper treatment of many popular products, tax practice in the area is frequently characterised by careful analysis of the economics of a particular structure and rigorous analogy to the most similar financial instruments for which there is clear treatment under the law. In ambiguous cases, practitioners commonly tend towards more conservative treatments that are less likely to be challenged by the IRS, especially in light of the fact that many issuances require an opinion of tax counsel as to their treatment.

For US investors, the fact that there will be a recognition event at some point during the term of the investment, at which time income, gain or loss will be recognised, is a foregone conclusion with respect to most investments. Thus, the critical tax issues are the timing and character of income, gain, loss or deduction. US taxpayers generally will prefer not to recognise gain until maturity (or until disposition, if they dispose of the instrument prior to maturity) and will prefer to recognise long-term capital gain rather than ordinary income. The benefits of capital versus ordinary treatment are twofold: first, capital losses can only be used to offset income other than capital gain in limited circumstances. Therefore, taxpayers with capital losses generally prefer that their gains be capital to allow them to utilise the capital losses. Second, for individual taxpayers, long-term capital gains are taxed on the federal level at a lower rate (currently, at a maximum rate of 20 per cent) than ordinary income (currently, at a maximum rate of 37 per cent). Thus, the tax impact to a US investor can differ significantly depending on whether the structure allows for deferral and whether tax items in respect of the investment are ordinary or capital.

For a non-US investor, the primary focus from a US tax standpoint is whether the investor will be subject to US withholding on payments received pursuant to the investment (assuming the income or gain from the investment is not effectively connected with a US trade or business conducted by the investor) or whether it can benefit from an exemption due to the characterisation of the particular type of payment in question. This will be a gating question for many non-US investors, who will not consider investing in an instrument that will result in US tax. Hence, the tax characterisation of a particular structured product is of critical importance for a non-US investor as well.


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ii Distinction between debt and non‑debt

Debt

The tax analysis of any structured product begins with the question of whether the product is treated as debt for tax purposes. Surprisingly, there is no general statutory or regulatory definition for what constitutes debt; the governing framework is rather a nebulous body of case law and IRS guidance. Under this framework, the most prominent feature of a debt instrument is an investor’s right to receive a fixed amount of money roughly equal to his or her initial investment at some definite point in the foreseeable future, commonly referred to as principal protection. Regular coupon payments, limited upside participation in the issuer, creditor enforcement rights and a lack of voting rights are other significant identifying features of debt. For many structured products, however, the deciding, and often sole, debt-like feature is the existence of principal protection with concomitant creditor rights. However, the threshold percentage of the principal amount that needs to be protected in order for an instrument to be considered debt is unclear. Market practice is generally to treat anything that is at least 90 per cent principal protected as debt. Notes with less than 80 per cent protection descend into an ambiguous netherworld in which practitioners often conclude that they cannot provide much comfort that an instrument will be respected as debt.

If an instrument is treated as debt, then a US investor is required to recognise ordinary interest income throughout the term of the instrument, and the issuer will generally be able to take interest deductions (subject to certain exceptions beyond the scope of this publication). If the instrument does not provide for stated interest that is unconditionally payable at least annually at a single fixed rate (qualified stated interest), a series of deemed payments will be imputed on a periodic basis – at minimum annually – and will be includible in income and generally deductible to the issuer as if actually paid. Similarly, if the instrument provides for qualified stated interest but is issued at a discount or provides for additional stated interest that does not meet the requirements described above, the excess of the total payments on the instrument that are not qualified stated interest over the issue price of the instrument is treated as accruing over the term of the instrument for tax purposes (subject to a de minimis exception). This excess is included in income as an original issue discount (OID) as it accrues, in accordance with a constant-yield method based on a compounding of interest. When a note is publicly traded and is subject to OID accrual, the issuer will file an IRS Form 8281 to inform the IRS that the note is subject to accrual of OID. The IRS periodically publishes a list of notes with OID and their required accruals online.

Subject to the discussion below concerning contingent payment debt instruments (CPDIs), gain or loss recognised by a US investor on the sale or other taxable disposition of an instrument treated as debt generally is treated as capital gain or loss and generally is long-term capital gain or loss if at the time of the sale or other taxable disposition the instrument has been held by the US investor for more than one year.

Debt instruments that provide for a variable rate of interest are subject to special rules. If the instrument provides for payment of interest at least annually at one or more floating rates that can be reasonably expected to measure variations in the cost of borrowing in the currency instrument’s denomination (a qualified floating rate), an objective rate that uses a single, fixed formula based on objective economic information (an objective rate), or a combination of a single fixed rate and one or more qualified floating rates, it will frequently be treated as a variable rate debt instrument (VRDI). VRDIs are generally subject to the same


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rules governing OID described above, but OID accruals will also be required when a VRDI provides for payment at two or more rates over its term with sufficient discrepancy between them to result in non-de minimis OID.

If an instrument that provides for a variable rate does not qualify as a VRDI, or if an instrument otherwise provides for a contingent payment that is not remote or incidental and is not subject to certain enumerated exceptions in the relevant Treasury regulations, then it generally will be subject to the regulations governing CPDIs. These regulations require accrual of interest income based upon a projected payment schedule, which must produce a yield equal to the issuer’s comparable yield (the yield at which the issuer would issue a fixed rate debt instrument with terms and conditions similar to those of the CPDI) and are determined at the time of issuance of the instrument. The rules provide for positive or negative adjustments to the amount of income or deductions attributable to the debt instrument in a taxable year for any differences between projected and actual contingent payments. In addition, any income on the sale, exchange, retirement or other taxable disposition of the instrument is treated as interest income rather than as capital gain. Accordingly, the qualification of a note as a VRDI and not as a CPDI can be particularly important.

Open transactions (non-debt)

Even if it is relatively clear that a structured product is not debt, there remains a question as to what the product is, in fact, for tax purposes. Although perhaps the most familiar contrast to debt is equity, structured products generally do not contain features emblematic of an equity investment. Structured products also generally do not provide the investor with any upside or downside economic exposure to the issuer (other than to the issuer’s credit risk) or give the investor any governance rights with respect to the issuer. Moreover, structured products have a limited term rather than an indefinite one. Thus, instruments that are not debt most commonly fall into the broader category of what are known as open transactions. Open transactions are transactions where, despite the fact that the taxpayer makes or receives certain upfront payments on the contract (or certain other payments prior to maturity), the taxpayer does not take those payments into account at the time they are received; rather, the total amount of gain or loss with respect to those payments is only calculated when the investment is closed out and final payments are made or received, against which earlier payments are netted to arrive at the total amount of gain or loss. The purchase of a cash-settled option is the quintessential example of an open transaction. Because whether the taxpayer recognises an economic gain or loss on the contract depends on whether, and the extent to which, the amount to be received upon disposition, lapse or settlement is in excess of the premium paid, the taxpayer does not recognise a loss at the time it makes a premium payment. Rather, the recognition event is deferred until the time that the gain or loss on the investment can be more fully ascertained.

While the Internal Revenue Code (Code) and the regulations promulgated thereunder provide rules explicitly addressing the treatment of certain kinds of open transactions (e.g., certain options and swaps), when an instrument cannot be squeezed into one of these rubrics, the character of the gain or loss at maturity or upon a disposition, and the treatment of any coupons paid under the instrument, is often a bit less clear. However, the Code provides a general framework for the treatment of a right or obligation that is ‘with respect to property which is [. . .] a capital asset in the hands of the taxpayer’. Under this framework, gain or loss attributable to the cancellation, lapse, expiration or other termination of such a right or obligation is treated as capital gain or loss, and will be long-term capital gain or loss if the instrument was held for more than a year.


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Component analysis

To further complicate the topography, there are times at which the most compelling tax treatment of an instrument is to bifurcate the instrument into its component parts and treat each component separately for tax purposes. Structured products are generally constructed from a combination of one or more derivatives and a loan. Although as a general matter case law and other authorities suggest that components of a derivative that are not economically separable (i.e., cannot, for example, trade separately) generally should not be treated as separate instruments for tax purposes, for certain structured products where the view is that bifurcation results in an approach that best mirrors economics, market practice is to separate out these components and treat them as separately taxable.

iii Non‑US investors

Certain types of US-source income of non-US investors (that is not effectively connected with the conduct of a trade or business in the United States, which generally results in the non-US investor being subject to US taxation in the same manner as a US investor) are subject to a withholding tax of 30 per cent of the gross amount paid unless a statutory or treaty-based exception applies. This withholding tax applies to interest, dividends and many other types of income, although it notably does not apply to gains from the sale or exchange of property. In the structured products context, this withholding tax commonly will not apply because:a the income is not US-sourced;b the income qualifies for an exemption for portfolio interest (an exception applicable to

many interest payments received by non-US investors who are not banks and who do not own a significant interest in the equity of the issuer); or

c the income is exempt under a treaty between the non-US investor’s home country and the United States.

Non-US investors are required to verify their identity as non-US persons and their eligibility for any applicable treaty benefits in order to qualify for any reductions or exemptions from withholding, and generally do so by providing the relevant IRS Form W-8 to the appropriate payor.

Section 871(m) and dividend equivalents

Prior to the addition of Section 871(m) to the Code, if a non-US investor entered into a derivative transaction with another non-US person that was linked to a US equity, there generally was no US withholding required on any payments on the transaction. Thus, a non-US investor was able to enter into a derivative that replicated the economics of an investment in a US equity and was able to receive the economic equivalent of a dividend from a US company without being subject to withholding. In 2010, Section 871(m) was enacted, and along with the implementing regulations, it restricts such workarounds by assessing a 30 per cent withholding tax (or lower treaty rate) on dividend equivalent amounts paid with respect to transactions that provide non-US investors with economic exposure substantially equivalent to a direct investment in US equities. Special regulatory tests apply for determining whether instruments give rise to dividend equivalents (including a delta test for instruments with simpler payouts under which instruments with a delta of 80 per cent or more are subject to Section 871(m) withholding tax). However, the IRS has clarified that for securities issued before 1 January 2021, this withholding will not apply with respect to most


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instruments unless the instrument has a delta of one. (Delta is the ratio of the change in the fair market value of the instrument to a small change in the fair market value of the number of shares of the underlying security.) Most equity-linked structured products do not have a delta of one and therefore are not currently subject to Section 871(m).

iv Application to common structured products

This section illustrates the principles described above by demonstrating their application to a number of common structured products.

Prepaid forwards

Prepaid forwards refer to a broad group of instruments that contemplate an upfront payment by an investor in exchange for a single payment at maturity linked to the performance of a particular reference asset (the underlier), whether physically settled or cash settled. They are commonly linked to an equity index, such as the S&P 500 or Russell 2000, to an ETF, or to one or more stocks. Common variants provide for a levered return with a maximum upside, or downside protection in the form of a buffer17 or a trigger.18 As long as any buffer or trigger feature is not so large as to raise the possibility of the instrument being characterised as debt (buffers of around 30 per cent and triggers of even 40 per cent or above are commonly treated as acceptable), these instruments are treated as open transactions resulting in capital gain or loss on maturity to US investors and no interim recognition of income. For non-US investors, any amounts received on these instruments generally will not be subject to US withholding tax.

Non-principal protected instruments with contingent coupons

Contingent coupon instruments are instruments linked to an underlier that pay a periodic coupon to the investor if the underlier is above a minimum threshold on the relevant testing date for the coupon. An investor typically does not participate in any upside at maturity, but bears the downside risk beyond a buffer or trigger. To compensate for this risk, the coupons are usually far in excess of prevailing interest rates. While the instrument itself generally is regarded as an open transaction, generating capital gain or loss to US investors at maturity, the proper treatment of the coupons is a matter of substantial uncertainty. As an economic matter, portions of the coupons may be characterised in various ways, such as option premium, interest on a loan, or a return of principal. Out of an abundance of caution, the market has adopted the view that these coupons are treated as unspecified ordinary income when received. This treatment, in conjunction with the fact that any losses at maturity are treated as capital losses, may produce adverse tax consequences to US taxpaying investors. For non-US investors, any capital gains generally will not be subject to withholding tax. However, due to the uncertain nature of the coupons, withholding agents may treat any coupon as subject to withholding (unless the investor qualifies for a treaty exemption).

17 A buffer is a minimum percentage decline in the underlier before which the investor is not subject to loss, and thereafter, loss is incurred on a 1:1 basis on amounts below the threshold such that, for example, a buffer of 30 per cent with a decline in the underlier of 31 per cent will yield a 1 per cent loss.

18 A trigger is a minimum percentage decline before which the investor is not subject to loss, and thereafter, the entirety of the loss is ‘triggered’ such that, for example, a trigger of 30 per cent with a decline in the underlier of 31 per cent, will yield a 31 per cent loss.


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Fixed-coupon instruments

Instruments that provide for fixed-rate coupons and are principal protected are treated as debt, as described above under ‘Debt’. Assuming that any OID is de minimis, the coupons are treated as interest (ordinary income), and gain or loss on disposition not attributable to interest is capital gain or loss. Non-US investors will generally be exempt from withholding on interest payments under the portfolio interest exemption.

Fixed-coupon instruments also come in non-principal-protected variations, which are linked to the performance of one or more underliers. An investor in such instruments generally bears the downside risk of the underlier or underliers (generally beyond a buffer or trigger) and may have no participation in the upside (reverse convertibles or reverse exchangeables) or may have limited participation in the upside (mandatory exchangeables). It is common practice to apply a component analysis to fixed-coupon instruments with no upside and to treat these instruments as a combination of a deposit by the investor with the issuer and a put option written by the investor to the issuer. A portion of each coupon payment is thus treated as interest on the deposit (determined by using the comparable interest rate the issuer would pay on similar loans) and includible in income when received, while the remaining portion is treated as premium on the put option. Under the tax rules governing options, a put premium is not taxable when received because it is unclear at that point whether the writer will ultimately have an economic gain or loss. Rather, if at maturity the underlier has not declined below any buffer or trigger and the initial investment (plus any final coupon) is returned to the investor (i.e., the put effectively expired unexercised), the total amount of premium is then taxable to a US investor as short-term capital gain. If, on the other hand, the US investor receives less than the entire initial investment, the investor recognises at maturity short-term capital gain or loss equal to the difference between the amount received at maturity (excluding any final coupon paid at maturity) plus the total put premium paid, and the initial investment amount (the deposit). The issuer generally publishes the portion of the coupon includible as interest and the portion attributable to put premium in the final disclosure accompanying the product documents.

For non-US investors, the portion of a coupon that is interest will generally qualify for the portfolio interest exemption, while any amounts that result in capital gain will generally not be subject to withholding.

When non-principal-protected fixed coupon instruments provide for some upside exposure at maturity, market practice is generally to treat the coupons as ordinary income under the same conservative approach used for contingent coupon notes described above. At maturity, if they are cash settled, a US investor recognises capital gain or loss generally equal to the difference between the initial investment and the amount received. If they are physically settled for stock, no gain or loss is recognised, and the investor takes the same tax basis in the stock as it had in the note. Upon disposition of the stock, the investor will then recognise capital gain or loss, as appropriate. As with non-principal-protected contingent coupon instruments, non-US investors may be subject to withholding on the coupons (unless a treaty exemption applies).

Equity-linked notes

Certain equity-linked notes are principal-protected instruments where the payment at maturity is linked to the performance of an index, a particular equity or a basket of equities. In one very common form, they are 100 per cent principal-protected and provide for no payment other than a payment at maturity reflecting the appreciation of the underlier (on


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a 1:1 or on a leveraged basis). Because they are principal-protected, they clearly are debt. However, as they do not provide for interest payments, but rather a contingent payment at maturity, they are treated as CPDIs. Accordingly, a US investor is subject to the rules governing CPDIs described above. Non-US investors generally will be exempt from withholding under the portfolio interest exemption.

v Afterword

The taxation of structured products is a nuanced field and commonly subject to some degree of uncertainty. Moreover, the relevant tax considerations may vary significantly based on an investor’s particular status and circumstances. Investors for whom tax considerations are important are best advised to carefully read the tax disclosure that accompanies an investment product and to seek expert guidance on the tax consequences applicable to their particular situation.

VI OTHER ISSUES

i The impact of the LIBOR transition

The transition from LIBOR to alternative reference rates will have a significant impact on the US structured product market as many structured products reference LIBOR. In addition to structured products that pay an interest rate based on LIBOR, LIBOR has also effectively been used as an underlying reference asset for structured products (e.g., the payment at maturity depends on the percentage change in LIBOR over the term). Further, many proprietary indices that are used as underlying reference assets for structured products have returns based on LIBOR or contain embedded costs or fees calculated by reference to LIBOR.

For legacy structured products, the contractual fallback language was typically intended to address a temporary unavailability of LIBOR, not its permanent discontinuation. For example, for interest-bearing products, the fallback language typically provides that if LIBOR is not available, the rate will be determined by reference to quotations by reference banks and, if the reference banks are not quoting, LIBOR for the relevant interest determination date will remain LIBOR for the immediately preceding interest reset period. The effect of this fallback language is that such products, which were intended to be floating rate instruments, will become fixed rate instruments, with the interest rate being fixed at LIBOR prior to its discontinuation, and no longer fluctuating based on changes in interest rates. As a result, in many cases, fallback language in legacy products will produce unintended economic outcomes. Unlike many English law-governed products, New York law-governed products typically require the consent of each holder to amend the interest rate.19

For new structured products, issuers can select an alternative interest rate to LIBOR at issuance. If the issuer wishes to continue to reference LIBOR at issuance, it can use fallback language that expressly contemplates and addresses the consequences of the discontinuation of LIBOR and related events. In this regard, the Alternative Reference Rates Committee, a group of private-market participants and regulators convened by the Federal Reserve Board

19 For additional information regarding the legal framework and other issues related to fallback language for legacy products, see Oliver Wyman and Davis Polk & Wardwell LLP, ‘LIBOR Fallbacks in Focus: A Lesson in Unintended Consequences’: https://https://www.oliverwyman.com/content/dam/oliver-wyman/v2/publications/2018/may/Oliver%20Wyman%20-%20LIBOR%20Fallbacks%20in%20Focus.PDF (accessed 31 July 2019).


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and the Federal Reserve Bank of New York, has published recommended fallback language for market participants to consider for new issuances of various types of cash products referencing LIBOR, including floating rate notes. The goal of this language is to reduce the risk of serious market disruption following a LIBOR cessation by providing for LIBOR to be replaced with a different rate (such as the Secured Overnight Financing Rate) following a trigger that precipitates the transition away from LIBOR. Published on 25 April 2019, this language has been used by issuers of structured products that pay an interest rate based on LIBOR, as well as those that effectively use LIBOR as an underlying reference asset.

ii Issues to consider with complex products

Regulators in the United States have long had, and continue to have, a focus on product complexity. This encompasses both complex structures and complex underlying reference assets.

In the case of FINRA, Notice to Members 05-26 (New Products), published by its predecessor, the National Association of Securities Dealers (NASD), began by noting that NASD was concerned about the number of increasingly complex products being introduced to the market, some of which were described as having unique features that may not be well-understood by investors and others of which were described as raising concerns about suitability and potential conflicts of interest. In describing procedures for vetting new products, NASD indicated that every firm should ask and answer, before a new product is offered for sale, whether complexity of the product in terms of structure, function or description impairs the understanding and transparency of the product and suitability considerations, or the training requirements associated with the product, or both.

More recently, in its Regulatory Notice 12-03 (Heightened Supervision of Complex Products), FINRA discussed the risks that it considered were raised by a number of different types of products, including the possibility that the product will not perform as many investors anticipate or that it might be inappropriately sold on the basis of enhanced yield, principal protection or the tracking of an index or a reference asset. According to FINRA, ‘[a]ny product with multiple features that affect its investment returns differently under various scenarios is potentially complex’, citing as examples ‘[p]roducts that include an embedded derivative component that may be difficult to understand’, such as ‘steepener’ notes and reverse convertible notes, and structured products with ‘worst-of ’ features. FINRA says:a the decision to recommend complex products to retail investors is one that a firm should

make only after the firm has implemented heightened supervisory and compliance procedures;

b firms should rigorously monitor the extent to which these procedures address the various investor protection concerns raised by the recommendation of complex products to retail investors; and

c firms should monitor the sale of these products in a manner that is reasonably designed to ensure that each product is recommended only to a customer who understands the essential features of the product and for whom the product is suitable.

In addition, in its 2019 Risk Monitoring and Examination Priorities Letter, FINRA indicated that firms should expect that FINRA will review for compliance regarding its ongoing areas of focus, specifically referencing obligations related to suitability determinations, including with respect to recommendations relating to complex products. This echoes themes raised in its December 2018 Report of FINRA Examination Findings, in which FINRA noted that


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it had observed unsuitable recommendations involving complex products and identified, as an example of one of the sound supervisory practices for suitability that it had observed, a requirement that registered representatives receive training on specific complex or high-risk products before recommending them so that the representatives understood the products’ risks and performance characteristics, as well as the types of investors for whom a product might be suitable.


The legal and regulatory environment in the United States as it relates to structured products is dynamic and continues to evolve. Regulation Best Interest, adopted in June 2019, is only the most recent in a series of significant regulatory developments that have impacted the ways in which structured products are offered and sold in recent years. At the same time, the structured products marketplace continues to grow and change. Manufacturers of structured products continually seek to innovate and design new products to help their customers meet their investment objectives. Developments such as open architecture and new technology platforms continue to change the ways in which structured products are distributed.

Despite this continual change, the central focus of regulators in the United States has remained constant: ensuring that structured products are sold only to investors who fully understand their features and risks and for whom they are appropriate. Disclosure is the cornerstone of the regulatory regime for securities in the United States, and ensuring that disclosures are full and fair and provide investors with an adequate basis on which to make an informed investment decision has long been a key focus of the SEC in the structured products area. The staff of the SEC regularly reviews disclosure documents filed by issuers with the SEC and has from time to time identified ways to improve disclosures. Many of the now-standard features of structured product disclosure in the United States, including disclosure of the estimated value of securities, product titles and certain ETN disclosures, can be traced to SEC disclosure reviews. SEC guidance is likely to continue to shape disclosure practices in the future. That is particularly likely to be the case with respect to new products, as the SEC staff actively encourages issuers to consult with it on disclosure issues that arise in connection with developing new products.

Although good disclosure is necessary, it is not by itself sufficient, and both the SEC and FINRA remain focused on ensuring that broker-dealers meet their sales practice obligations in connection with sales of structured products. Those obligations include understanding the terms of the securities the broker-dealer is recommending (good disclosure is essential in this regard) and ensuring that recommendations are suitable for, and, after the effectiveness of Regulation Best Interest, in the best interest of, their customers. We expect these areas to remain a continued focus of regulators in the United States in the years to come.


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Appendix 1

ABOUT THE AUTHORS

JOSÉ LUIS AMBROSY

Claro & CiaMr Ambrosy, partner, has concentrated his practice on corporate finance, capital markets, international finance transactions (including both corporate and project finance) and mergers and acquisitions.

He has represented a broad range of clients, including lenders, borrowers, purchasers, sellers, governments, investors, financial advisers, issuers, credit enhancers and underwriters. He has worked in projects involving regulatory authorities in the Chilean securities market and public work concessions in Chile.

He joined Claro & Cia in 1998. Previously, he practised law in the legal department of a financial institution in Madrid, Spain (1996–1998). In 2003 and 2004 he worked as a foreign associate with the project finance team at Debevoise & Plimpton, LLP, New York Office.

He holds an LLM from University of Notre Dame School of Law (2004) and a JD from Universidad de Alcalá de Henares, Madrid (1997).

He is admitted to practise in Spain and Chile, and he speaks Spanish and English.

NAOYA ARIYOSHI

Nishimura & AsahiNaoya Ariyoshi is a partner at Nishimura & Asahi. He specialises in finance transactions, especially in the areas of securitisation and structured finance, and trust transactions, and in finance regulations. With respect to the field of finance transactions, his extensive experience includes securitisation transactions regarding a wide variety of receivables and other asset classes as legal counsel for originators, arrangers and trustees, and he has worked on structured finance transactions involving various schemes, including those uniquely achieved for the first time in Japan. Furthermore, as he has worked at the Financial Services Agency of Japan in the Corporate Accounting and Disclosure Division of the Planning and Coordination Bureau, and gained experience in the planning of financial regulations there, in addition to his skills developed through his experience as a lawyer in the area of finance he has acquired a detailed knowledge of various financial regulations. Accordingly, he has provided advice to many financial institutions, including banks, trust banks, securities firms, insurance companies, non-banks and Fintech companies.


About the Authors

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LUCILE CESAREO-HOSTETTLER

lecocqassociateMs Lucile Cesareo-Hostettler is one of lecocqassociate’s emerging talent, specialising in mergers and acquisitions, capital markets, banking and corporate finance law and estate planning. She graduated from the Law Faculty of the University of Geneva in 2014. She obtained a master in economic law in the fields of economic criminal law and corporate law and undertook her master’s thesis on corporate social responsibility. In July 2016, she obtained a certificate of advanced studies in legal professions and passed the Geneva Bar in May 2018 after completing her internship at lecocqassociate.

RAFAEL JOSÉ LOPES GASPAR

Pinheiro Neto AdvogadosRafael Gaspar is a senior associate in Pinheiro Neto’s banking and finance and capital markets departments, practising in the São Paulo office. His practice includes domestic and cross-border banking and finance transactions, derivatives, agribusiness finance, mergers and acquisitions, debt restructuring and capital markets transactions. Rafael holds an LLM from the University of California, Berkeley (2016), a certificate in business administration from Insper – Instituto de Ensino e Pesquisa (2013) and degree in law (LLB) from Pontifícia Universidade Católica de São Paulo (2008). Rafael worked at Clifford Chance as a foreign consultant from 2010 to 2011. He is also recognised as a notable practitioner by IFLR1000 in equity capital markets, debt capital markets, and banking and finance.

FÁBIO MORETTI DE GÓIS

Pinheiro Neto AdvogadosFábio Moretti de Góis is an associate in Pinheiro Neto’s corporate department, practising in the São Paulo office. His practice focuses on developing strategies for complex corporate and financial transactions, particularly domestic and cross-border financing, agribusiness securitisation, structured issuances and derivative products. Fábio received his bachelor’s degree from Pontifícia Universidade Católica de São Paulo in 2015 and is currently completing a master of laws in the corporate area at Insper – Instituto de Ensino e Pesquisa. In 2018 and 2019, Fábio was recognised by the International Financial Law Review as a notable practitioner in four different areas: banking and finance; capital markets – debt; capital markets – derivatives; and capital markets – equity.

DOMINIQUE LECOCQ

lecocqassociateMr Dominique Lecocq is an expert in the field of banking and finance law and stands out for his pragmatic approach and unparalleled legal expertise. He was admitted to practise law in Switzerland and in Malta and graduated from the School of Law of the University of Geneva in 1999. He gained a masters of law in securities and financial regulation from Georgetown University in 2005.

Before founding lecocqassociate, Mr Dominique Lecocq served with the London office of Radcliffes Solicitors in 1998. He worked in 1999 as a foreign associate with Pinheiro Neto Advogados, in São Paulo, Brazil. From 2000 to 2004, he joined as an associate at the


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regulatory and capital market practice group of Pestalozzi law firm in Geneva and Zurich. In 2005, he interned with the commodities futures trading commission in Washington, DC. Finally, from 2005 to 2007, he served with the corporate finance and regulatory practice group of Schellenberg Wittmer, in Geneva.

Mr Dominique Lecocq regularly participates in a variety of important conferences, seminars and round-table meetings by sharing his knowledge and experience. On 7 April 2019, he spoke at the largest conference for alternative investments in the Middle East and North Africa region, which was held in Abu Dhabi. Over 500 investors and investment managers attended this event. The last time Mr Dominique Lecocq participated as a speaker was on 12 June 2019 at the Geneva edition of the Alternative Investment Management Summit, during which Mr Dominique Lecocq spoke about structured fundraising. For more details, see https://lecocqassociate.com/news/structured-fundraising-aim-summit-geneva-2019/.

Mr Dominique Lecocq is a member of the board of directors of one broker-dealer in Switzerland, one bank in Dubai and two prominent hedge funds, as well as one very large and prominent family office in Geneva.

MIKA J LEHTIMÄKI

Attorneys-at-Law TRUST LtdMika is one of the leading banking and M&A lawyers in Finland. He has extensive experience of Finnish and cross-border M&A, banking and financial transactions in the Nordic area and Russia. Mika graduated from the University of Helsinki, and he holds two postgraduate law degrees from the University of Oxford. He also acts as a financial and M&A researcher and a game-theorist at the University of Oxford.

Mika has, throughout his career, served especially the interests of foreign clients in complex financing and M&A transactions taking place in Finland. The most notable transactions have been prominent public-to-private transactions and more recently corporate restructurings and complex inter-creditor issues.

TIAGO A D THEMUDO LESSA

Pinheiro Neto Advogados Tiago Araujo Dias Themudo Lessa has been a member of the corporate area of Pinheiro Neto Advogados since 1997, and is based in São Paulo. His practie includes banking law (including regulatory, derivatives and foreign exchange matters), corporate law, aviation law, mergers and acquisitions, capital markets, regulation of financial institutions, project finance and agribusiness law. He holds a bachelor’s degree in law from Universidade Mackenzie (2000), an LLM in financial markets law from INSPER (2003) and a certification of introduction to US law from New York University (2008). He worked as a foreign associate at Allen & Overy LLP (New York, 2007–2008). He is a native speaker of Portuguese and is fluent in English.

CHRISTOPHER S SCHELL

Davis Polk & Wardwell LLPMr Schell is a partner in Davis Polk’s corporate department, practicing in the derivatives and structured products group. He regularly advises financial institutions on numerous types of domestic and international debt and equity capital markets transactions. He represents issuers and investment banks. His practice focuses on advising financial institutions in connection


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with their capital markets offerings and issues related to those offerings such as the Federal Reserve’s TLAC rules or the current LIBOR transition. Within this capital markets practice, he has over a decade of expertise in structured product transactions, including synthetic exchangeable securities and other equity, commodity and currency linked products. He has extensive experience developing new financial products, including innovative offerings of units, warrants, exchange traded notes and proprietary indexes, for both retail and institutional investors.

YUKI TAGUCHI

Nishimura & AsahiYuki Taguchi is an attorney at Nishimura & Asahi specialising in finance. He engages in various financial transactions such as securitisation, acquisition finance and asset management, and handles financial regulations. He spent one year as a secondee at the London office of a Japanese bank, where he was involved in reviewing various banking products as an EMEA Legal Office member. He was admitted to the Bar in Japan in 2010 and New York in 2018.

DEREK WALTERS

Davis Polk & Wardwell LLPMr Walters is a partner in Davis Polk’s corporate department, practicing in the derivatives and structured products group. He advises financial institutions, companies and investors on equity derivatives and other structured transactions, including convertible notes, margin loans secured by significant positions in public companies, over-the-counter derivatives and structured products. His practice encompasses transaction execution as well as product development and regulatory compliance.

TOSHIYUKI YAMAMOTO

Nishimura & AsahiToshiyuki Yamamoto is an associate at Nishimura & Asahi. His main practice areas are asset management and derivatives. He is also involved in finance transactions and regulatory matters as well as foreign regulatory defence and litigation. Prior to joining a Japanese law firm and starting his career as a lawyer in 2009, he worked in the field of securitisation at a domestic credit rating agency and at the Tokyo office of a global investment bank as an analyst. He is a certified member analyst of the Securities Analysts Association of Japan and a certified international investment analyst. He regularly serves as a speaker at conferences for the ISDA Master Agreement held by the International Swaps and Derivatives Association. Recently, he has published articles and given a presentation regarding artificial intelligence in finance industries.

YAN ZHANG

Davis Polk & Wardwell LLPMs Zhang is a partner in Davis Polk’s corporate department, practicing in the derivatives and structured products group. She regularly represents financial institutions on securities offerings of structured products linked to equities, commodities, currencies, rates and combinations of these assets. She has extensive experience in the development of new


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81

financial products, including exchange traded notes and proprietary indices for retail and institutional investors. She also advises financial institutions, corporations and investment funds in structuring, negotiating and documenting equity derivatives transactions as well as offerings of convertible and exchangeable securities.


83

Appendix 2

CONTRIBUTORS’ CONTACT DETAILS

ATTORNEYS-AT-LAW TRUST LTD

Erottajankatu 13 00130 HelsinkiFinlandTel: +358 40 534 [email protected]

CLARO & CIA

Av Apoquindo 3721, 14th floor755 0177 SantiagoChileTel: +56 2 2367 3000Fax: +56 2 2367 [email protected]

DAVIS POLK & WARDWELL LLP

450 Lexington Avenue10017 New York, NYUnited StatesTel: +1 212 450 4011/4463/4235/4000Fax: +1 212 450 5759/4990/6852 [email protected]@[email protected]

LECOCQASSOCIATE

42, route de Frontenex1207 GenevaSwitzerlandTel: +41 22 707 9333Fax: +41 22 786 [email protected]@lecocqassociate.comwww.lecocqassociate.com

NISHIMURA & ASAHI

Otemon Tower1-1-2 OtemachiChiyoda-kuTokyo 100-8124JapanTel: +81 3 6250 6406/6612/6616Fax: + 81 3 6250 [email protected][email protected][email protected]/en

PINHEIRO NETO ADVOGADOS

Rua Hungria, 1100 01455-906São PauloBrazilTel: +55 11 3247 8400Fax: +55 11 3247 [email protected]@[email protected]


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ISBN 978-1-83862-035-6

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