Circular 1/2018 of the National Securities Market Commission on Warnings Regarding Financial Instruments

OFFICIAL STATE GAZETTE
No. 75 Tuesday, March 27, 2018 Sec. I. Page 33348
I. GENERAL PROVISIONS
NATIONAL SECURITIES MARKET COMMISSION
4247 Circular 1/2018, of March 12, of the National Securities Market Commission, on warnings regarding financial instruments.

I
Informational transparency constitutes one of the fundamental pillars of the conduct rules governing the provision of investment services. In recent years, a growing sophistication of financial instruments offered to retail clients has been observed, such that, in response to the demand for higher returns, access to increasingly complex instruments is being facilitated. Cases of inappropriate marketing of financial instruments occurring in our market have highlighted deficiencies in retail clients' understanding of the nature and risks of financial instruments when making investment decisions.

Therefore, it is necessary to reinforce the informed consent of retail clients when they purchase investment products, especially when these are particularly complex. It must be taken into account that current regulations allow retail clients to acquire any type of product, no matter how complex or risky, even when the marketing entity considers that the product is not suitable for its client and has warned them accordingly.

While the growing sophistication of financial instruments, and the increasingly frequent access by retail clients to them, would suggest that for particularly complex products, such retail clients should have investment advice from a professional (who, before recommending the purchase of the product, should assess the client's financial situation and investment objectives, as well as their knowledge and experience), it is also compatible with the current regulatory framework for entities to offer them to unadvised retail clients.

For this reason, when entities decide to market this type of sophisticated products outside the scope of investment advice, without assessing suitability and therefore analyzing only the investor's knowledge and experience, retail clients must be clearly warned of the high complexity of the instrument in question, as the assessment and understanding of all its risks may entail special difficulty for them. Therefore, to ensure informed consent and that protection for retail clients is effective, it is deemed appropriate that the warning in this case be accompanied, along with the client's signature, by a handwritten expression.

Additionally, instruments of this type that clients have acquired previously and hold on the date of entry into force of this circular must be identified and subject to a warning, once only, in the first position statement to be sent to retail clients after said entry into force.

II
Furthermore, Law 11/2015, of June 18, on the recovery and resolution of credit institutions and investment service companies, has regulated the so-called internal recapitalization instrument, the legal translation of the English term "bail in." The ultimate purpose of this instrument, as stated in the preamble of the aforementioned Law, is to internalize the cost of resolution within the financial entity itself. cve: BOE-A-2018-4247 Verifiable at http://www.boe.es

OFFICIAL STATE GAZETTE
No. 75 Tuesday, March 27, 2018 Sec. I. Page 33349 In a resolution scenario for an entity (a process applicable when the entity is or is likely to become unviable in the near future and, for reasons of public interest and financial stability, it is necessary to avoid its bankruptcy liquidation), the liabilities eligible for the internal recapitalization of said entity could be converted into shares or have their principal reduced, and consequently, the holders thereof would bear significant losses. Unlike the hybrid management mechanisms contemplated by Law 9/2012 of November 14, on the restructuring and resolution of credit institutions, which limited loss absorption to subordinated debt, in the case of internal recapitalization, loss absorption can reach all types of creditors.

Therefore, within the scope of competencies attributed to the National Securities Market Commission and through this circular, the informed consent of retail clients is reinforced when they purchase investment products that are, in turn, liabilities eligible for internal recapitalization, establishing a specific warning regarding this, which must be provided when such instruments are to be acquired.

Additionally, instruments of this type that clients have acquired previously and hold on the date of entry into force of this circular must be identified and subject to a warning, once only, in the first position statement to be sent to retail clients after said entry into force.

This approach is consistent with the communication of June 2, 2016, on MIFID practices for the marketing of financial instruments subject to the Bank Recovery and Resolution Directive (ESMA/2016/902) of the European Securities and Markets Authority.

III
Furthermore, retail clients find it difficult to estimate the current value of certain instruments at the time of their acquisition or sale, especially when dealing with financial instruments whose final return is conditioned by the evolution of one or more underlying assets.

In the case of complex issuances directed at retail clients, when a significant difference is revealed between the placement price and the market value that professional and qualified investors would require, the National Securities Market Commission has been requiring the inclusion of a warning highlighting this circumstance in the informational documents of the financial instrument, an aspect considered necessary to normalize not only in these cases but also in others addressed in this circular.

Therefore, with the aim that retail clients are adequately informed, it is convenient that, for certain types of products that are not sufficiently transparent regarding all the costs and expenses they incorporate, the client be warned when there is a significant difference between the estimate the marketing entity makes regarding the current value of the instrument and the price or effective amount at which the retail client is going to operate, including, where applicable, the explicit commissions that apply.

IV
The third final provision of Law 9/2012, of November 14, on the restructuring and resolution of credit institutions, introduced certain modifications to Law 24/1988, of July 28, on the Securities Market. One of them affected paragraph 3 of Article 79 bis –the current paragraph 3 of Article 210 of the consolidated text of the Securities Market Law– relating, among other issues, to the information that entities must provide to their clients regarding financial instruments. Said article empowers the National Securities Market Commission to require that, in the information delivered to investors prior to the acquisition of a financial instrument, any warnings regarding the financial instrument deemed necessary be included, and in particular, although not exclusively, those highlighting that it is a financial instrument not suitable for non-professional investors due to its complexity.

The objective of this measure is to reinforce investor protection and is complementary to other modifications introduced by the same Law 9/2012, of November 14, such as those regarding warnings and information to clients contemplated in paragraphs 6 and 7 of that same Article 79 bis of Law 24/1988, of July 28 –the current Articles 213 and 214 of the consolidated text of the Securities Market Law–, already developed through Circular 3/2013, of June 12, of the National Securities Market Commission, on the development of certain information obligations to clients to whom investment services are provided, regarding the assessment of the appropriateness and suitability of financial instruments.

The preamble of the aforementioned Law 9/2012, of November 14, itself highlights that its contents intensify the control powers held by the National Securities Market Commission regarding the marketing of investment products by entities, especially regarding complex products.

This circular is issued pursuant to the power attributed to the CNMV to require that in the information delivered to retail clients prior to the acquisition of a financial instrument, certain warnings regarding the instrument be included. The purpose of this regulation is to specify the warnings to be made related to the high degree of complexity, their eligibility for internal recapitalization, or the existence of a significant difference regarding the current value. To this end, different types of financial instruments and the nature of the client have been taken into consideration.

V
The circular consists of four rules, a transitional provision, and a final provision.

The first rule covers the scope of application, which refers to the provision of investment services other than discretionary portfolio management to retail clients in Spanish territory by the following companies: investment service companies, credit institutions, or management companies of collective investment institutions in Spain, branches of the aforementioned in the Community or third countries, and their agents established in Spain, as well as investment service companies, credit institutions, or management companies of collective investment institutions from states not members of the European Union that provide such services without a branch.

The second rule details which financial instruments, in general, are not suitable due to their high complexity, in the opinion of the CNMV, for retail clients. It establishes the content of the warning to be made to both retail clients who have professional advice and those who do not, taking into account that, according to the analysis of the personal characteristics of such retail clients made by the entities, they may be judged convenient or suitable. It also specifies the manner in which such warnings must be made. In determining these instruments, attention has been paid to those types of especially complex instruments that, in recent years, have been marketed on some occasions among the retail public. Therefore, there may be others of high complexity that, given their scarce or non-existent dissemination currently among the retail public, have not been included at this time in this circular, which is why the possibility is foreseen that the CNMV may decide in the future to add other instruments to the list.

The third rule details the warnings to be made when retail clients are going to acquire a financial instrument that is, in turn, a liability eligible for internal recapitalization.

The fourth rule identifies a series of financial instruments for which retail clients must be warned, informing them, in the documentation to be delivered when they are going to acquire or sell the product, of the existence of a significant difference between the effective amount at which the operation will be carried out, including, where applicable, the explicit commissions that apply, and the estimate the entity makes of its current value. Specifically, the circular establishes in which cases a significant difference must be considered to exist and the manner in which this warning should be made.

The transitional rule establishes that financial instruments especially complex that generally are not suitable for retail clients and financial instruments that are, in turn, liabilities eligible for internal recapitalization that clients hold upon the entry into force of this circular must be identified and subject to a warning, once only, in the first position statement to be sent to retail clients after said entry into force.

The Council of the National Securities Market Commission, in its meeting of March 12, 2018, in exercise of the conferred powers, in accordance with the Council of State and prior report of the Advisory Committee and the Bank of Spain, has ordered:

First Rule. Scope of Application.
This circular shall apply to the following entities when they provide investment services other than the service of discretionary and individualized portfolio management provided for in Article 140.d) of the consolidated text of the Securities Market Law, approved by Royal Legislative Decree 4/2015, of October 23, to retail clients in Spain:
a) Investment service companies mentioned in Article 143 of the consolidated text of the Securities Market Law, approved by Royal Legislative Decree 4/2015, of October 23, including natural persons who have the status of financial advisory companies. b) Credit institutions and management companies of collective investment institutions mentioned in Article 145 of the consolidated text of the Securities Market Law, approved by Royal Legislative Decree 4/2015, of October 23, as entities authorized for the provision of certain investment services and auxiliary services. c) The following foreign entities:

1. The branches in Spain of the entities mentioned in letters a) and b) above, which are authorized in a Member State of the European Union or in a third State.
2. The entities mentioned in letters a) and b) above, which are authorized in a Member State of the European Union, when operating in Spain through an agent established in national territory.
3. The entities mentioned in letters a) and b) above, which are authorized in a non-member State of the European Union, when operating in Spain without a branch.

Second Rule. Warnings regarding financial instruments especially complex that generally are not suitable for retail clients.

1. The following financial instruments are subject to the provisions contained in paragraphs 2 to 11 of this rule:
   a) Financial instruments that, according to the solvency regulations of credit institutions, are computable as Level 1, Additional Level 1, or Level 2 own funds and equivalent instruments from third countries. Shares that, according to what is established in Article 217 of the consolidated text of the Securities Market Law, approved by Royal Legislative Decree 4/2015, of October 23, have the status of non-complex financial instruments are excluded. cve: BOE-A-2018-4247 Verifiable at http://www.boe.es

OFFICIAL STATE GAZETTE
No. 75 Tuesday, March 27, 2018 Sec. I. Page 33352 b) Bonds, debentures, and other analogous negotiable securities representing debt, and financial contracts not traded on official secondary markets through which a credit institution receives cash from its clientele assuming an obligation to repay within a determined period, consisting of the delivery of securities, the payment of a sum of money, or both, when the issuer does not assume the commitment to repay, at maturity, a percentage equal to or greater than 90% of the amount received, and always provided that, in addition, their result or amount to be repaid is linked to the occurrence of events related to the credit risk of one or more entities. c) Bonds, debentures, and other analogous negotiable securities representing debt, included in letter c) of paragraph 1 of Article 2 of the consolidated text of the Securities Market Law, approved by Royal Legislative Decree 4/2015, of October 23, when their issuer does not assume the commitment to repay, at maturity, a percentage equal to or greater than 90% of the initial investment, with the return of the remaining percentage conditioned on the evolution of one or more specific underlying assets, always provided that, in addition, they incorporate complex structures that make it difficult for a retail client to understand the risks associated with the instrument. d) Financial contracts not traded on official secondary markets, through which a credit institution receives cash from its clientele assuming an obligation to repay within a determined period, consisting of the delivery of securities, the payment of a sum of money, or both, conditioned based on the evolution of one or more specific underlying assets, when the credit institution does not assume the commitment to repay, at maturity, a percentage equal to or greater than 90% of the amount received and always provided that, in addition, they incorporate complex structures that make it difficult for a retail client to understand the risks associated with the instrument. e) Collective investment institutions with a specific return objective, guaranteed or not, for a determined period, when at said period the fixed objective is not equal to or greater than 90% of the investment, with the achievement of said objective conditioned on the evolution of one or more specific underlying assets and being subject to calculation according to an algorithm, always provided that, in addition, they incorporate complex structures that make it difficult for a retail client to understand the risks associated with the instrument. f) Financial contracts for differences and binary options. g) The rest of the financial instruments included in paragraphs 2, 3, 5, 6, and 8 of Article 2 of the consolidated text of the Securities Market Law, approved by Royal Legislative Decree 4/2015, of October 23, except when they are derivative instruments traded on regulated markets, multilateral trading facilities, or organized
trading facilities, and always provided that they incorporate complex structures that make it difficult for a retail client to understand the risks associated with the instrument. Financial derivative instruments offered by the entity to the client with the purpose of providing coverage, or reducing the financial risks assumed by other pre-existing specific financial positions or commercial operations, are excluded, always provided that the financial entity marketing them has previously verified that they substantially fulfill said purpose. h) Others that, after a specific analysis, are determined by the National Securities Market Commission, once it has communicated or published such decision.

2. For the purposes of this rule, it will be considered that there is a complex structure that makes it difficult for retail clients to understand the risks associated with the instrument, when the underlying asset or any of the underlying assets, in case there is more than one, is not traded daily in a market where a daily price is disseminated obtained from cross-buying and selling operations between independent parties, or in the case of underlying assets that are collective investment institutions, when their net asset value is not published daily.

Additionally, in the case of the instruments referred to in letter g) of paragraph 1), it will also be considered that there is a complex structure that makes it difficult for retail clients to understand the risks associated with the instrument when, although the underlying asset is traded daily in a market where a price is disseminated obtained from cross-buying and selling operations between independent parties, the instruments have a high speculative purpose. For these purposes, it will be understood that financial instruments have a high speculative purpose when the client can close or cancel their positions continuously during the life of the instrument at any time before its maturity.

3. Entities providing investment services within the scope of application of this circular other than investment advice regarding any of the financial instruments provided for in paragraph 1 must make a warning to retail clients with the following content:

"Warning:
You are about to acquire a product that is not simple and that may be difficult to understand: (the product must be identified). The National Securities Market Commission (CNMV) considers, in general, its acquisition by retail clients to be unsuitable due to its complexity. Nevertheless, ZZZ (name of the entity) has evaluated your knowledge and experience and considers that it is convenient for you."

In the case of instruments included in paragraph 1 where the retail client may assume financial commitments for an amount greater than the acquisition cost of the instrument, a second paragraph must be added to the warning, with the following content:

"This is a leveraged product. You must be aware that losses may exceed the amount initially paid for its acquisition."

This warning shall be made regardless of whether, where applicable, the Key Information Document for investors that must be delivered to the client in accordance with Regulation (EU) No 1286/2014 of the European Parliament and of the Council, of November 26, on key information documents for packaged retail and insurance-based investment products, contains the comprehension warning referred to in Article 8, paragraph 3, letter b), of said Regulation.

4. The entity must obtain the signature by the retail client of the text referred to in the previous paragraph, joined by a handwritten expression by the same stating:

"Product difficult to understand. The CNMV considers that, in general, it is not suitable for retail investors."

5. In the case that, in addition to the warning referred to in paragraph 3, the entity must also make the warning that it considers that the service