PRIIPS: Could "Level 1" really go it alone?

On 14th September 2016, the European Parliament (EP) confirmed rejection of the PRIIPS RTS which had been developed and proposed by the European Commission (EC). I discussed the some of the reasons for this in a previous post on LinkedIn: PRIIPS - what happens now?

The vote last week confirmed the EP Economic committee’s rejection from two weeks earlier which threw a major spanner in the works of the whole PRIIPS timetable, threatening the implementation date of 31 December 2016 which was determined by the “Level 1” legislation when it was passed two full years ago. This legislation explained in broad terms what the PRIIPS regulation is supposed to achieve and how it should do so (primarily through the creation of the Key Investor Document or KID). By regulatory standards this legislation document was relatively short and high level (and therefore actually remains clear when read standalone) and it required the existence and passing of more detailed Regulatory Technical Standards (RTS, or “Level 2”). It is this Level 2 regulation which has now been rejected by Parliament.

Therefore logically there are three scenarios from here. The first is that the implementation date is put back in order to allow revised RTS to be developed and agreed. This would appear to be the most sensible outcome and certainly the one hoped for by most in the investment industry to improve the quality of the RTS and allow sufficient time for preparation. However this requires amendment to the Level 1 legislation. The second is to keep the timetable intact but make a last minute revision of the RTS, probably with some implied consultative or informal status but this seems extremely unlikely as Parliament would have no chance to approve it and in any event it would leave firms very little time to prepare.

The third scenario - which even six months ago  would have seemed utterly inconceivable - is that Level 1 is left to come into force with no agreed and operational Level 2 RTS in place. Essentially this means that firms would have to comply with the regulation without any clarity of what is required yet with the threat of regulatory action or investor claims in the event that KIDs are non-existent, misleading, not updated sufficiently or otherwise inadequate.

This third scenario is the focus of this article – could “Level 1” really go it alone?

The first key question is what will investment firms be likely to do in such a situation once January 1 2017 passes and PRIIPS has gone into force?

It would seem that the logical and prudent thing to do would be to issue KIDs in line with the RTS as they are currently prescribed simply because they “on the table” even if they are the direct stumbling block in this process and almost certain to be changed. Andreas Widegren (Head of trade body The Swedish Structured Investment Products Association) commented to me that firms would essentially treat this period as a dry run until the regulation is clearer, since they already have systems and processes in place to deal with the advent of PRIIPS. He also stated that them being put in such a position is highly unsatisfactory.

I believe that it would be likely that firms caveat the KID content by stating that they are providing information to the investor under their obligations on a best understanding and good faith basis in the absence of full requirements.

This situation is bad enough once January 1st passes and may well lead to significant reduction in new product development and issuance. Peter Green (Partner at law firm Morrison and Foerster) said to me that he expected that some more complex or higher risk products in particular may be withdrawn. Additionally it may be that firms and their distributors or intermediaries are much more reluctant to take on new clients because there is less ability for them to demonstrate investor knowledge through previous transactions. Widegren added that this will hurt SMEs the most and while he recognised that PRIIPS is important regulation for investors under this scenario it would seriously impact the ability for firms to do business satisfactorily threatening their financial health. This cannot be a sensible situation in a world where fees are already under pressure from increased competition.

However the situation could get more confusing deeper into 2017. If a consultation process rumbles on during the early part of the year how quickly are firms expected to react and implement any RTS changes into their KID production? There could well be several rounds of changes and different firms will change their KIDs at different times leading to loss of consistency and greater confusion for investors, another highly unsatisfactory outcome. This could be prevented if the EC shows greater logic and foresight than it has thus far by stipulating that implementation of a revised and agreed RTS will take place at some fixed given date (for example July 2017) and that firms need not make any changes to their KID output until that time. This would provide some breathing space and give greater consistency across firms but the problem is that once Level 1 is in place it is not clear what the status of such guidance would be. Widegren also noted that firms also have another significant burden in order to prepare for MiFID II in 2018 and that any significant delay in PRIIPS would impact this because many firms would use the same people and IT resources for both projects and would struggle to implement them at short notice in parallel.

This brings us onto the next consideration that as with any other regulation, non-compliance has risks of enforcement action however both Green and Widegren agreed that such action would be “extremely unlikely” as long as firms had done something broadly reasonable under the circumstances.

However the threat of investor action is harder to discount, as is generally the case when considering how to protect against civil compensation claims. While Green said that it is hard to see how a firm could be held to be in breach of regulations that were not fully defined he said there is always that possibility. The danger is that success in any relevant court cases would set a precedent that might be hard to overturn, certainly in the particular country that it happens in.

Even if this whole nightmare scenario does come to pass, fully defined RTS will eventually come into place of course, however the long lasting impact and credibility damage to this regulation will I believe be significant. How can such an important piece of regulation recover from a chaotic opening year?

I would advise any affected firm to consider their position as long as this scenario remains possible. For anyone that still refuses to believe it can happen do not forget that it is currently the status quo outcome – if neither the EP or EC move in the next three months it will happen.

We should all hope that the EC accepts the mistakes that have happened, implement a six month delay of implementation to July 2017 in no longer than the next six weeks, and fast track RTS changes that get Parliamentary approval by February 2017 at the very latest. This I believe is the best compromise for all concerned. We cannot have Level 1 going it alone.

A version of this article was published in Investment Week.