21 August, 2018
ASIC is examining the allocations process in capital raising transactions. Senior Associate Addison Ma discusses ASIC's allocations project and the influences that the regulators in the UK and in Europe may have on the project.
BUSY TIMES
Regulator activity in the Australian equity capital market space has never been more active, as highlighted by the 2016 ASIC report on sell-side research and corporate advisory conflicts (REP 486) and the follow-up regulatory guide in December 2017 (RG 264), the recent criminal cartel case brought by the ACCC (MR 103/18), and the recent enforceable undertaking by a licensee following ASIC's investigation into bookbuild messaging in a block trade transaction (MR 18-198).
THE ALLOCATIONS PROJECT
In the midst of the above, ASIC has also been working away in the background, looking into the allocation processes in both primary and secondary capital raisings.
In February 2018, ASIC flagged to the market (Market Article: Reviewing allocations practices in capital raising transactions) that it would be looking closely at allocation practices in a number of ECM transactions, and consulting with industry players (including licensees, corporate advisers, corporate issuers and investors), although we understand anecdotally that this review had already begun in 2017.
ASIC Commissioner Cathie Armour reiterated this 'allocations project' in a speech at the Stockbrokers and Financial Advisers Conference in May 2018 (Professionalism and other things), noting that market participants should expect to receive notices from ASIC (if they haven't already) requiring them to inform ASIC of their involvement in capital raisings, with a view to seeing how the allocation process occurs. ASIC's position is that it wants to see, among other things, 'how the book was built', a 'fair allocation process' and firms being 'able to demonstrate how the allocation process reflects the interests of their issuer client'.
Outside of the two above public statements, it is currently unclear where ASIC will land on its review and what, if any, guidance or other regulatory intervention it may provide/pursue once it concludes its review. However, ASIC has stated that it has also been in discussions with international regulators to understand their regulatory approach to allocations, and it is likely this will influence ASIC's final position on the issue.
Given this, it is useful to consider the approach on allocations that the UK Financial Conduct Authority (the FCA) has taken in initial public offerings (IPOs), following a broader market study into investment and corporate banking in 2015/2016, as well as the requirements that came into effect on 3 January 2018 under the European Union Markets in Financial Instruments Directive (MiFID II). These two offshore examples may provide some insight into where ASIC may eventually land once it concludes its allocations project.
THE FCA'S APPROACH
In its Occasional paper 15: Quid pro quo? What factors influence IPO allocations to investors (the Occasional Paper 15), the FCA reported on a statistical and empirical review of 220 IPOs conducted in or from the UK1 between January 2010 and May 2015, focusing on conflicts in IPO allocations; the relationship between investment banks and IPO investors, and whether this relationship drove allocations; practices among different banks; and the favouring of investors who held onto their shares or provided liquidity in the after-market.
Key findings from Occasional Paper 15 included:
- Bookrunners making favourable allocations to investors to whom they generate the greatest revenues elsewhere in their business (largely through brokerage commissions). These preferential allocations were strongest in 'hot' IPOs.
- Bookrunners favouring investors who provide them with information that may be useful in pricing the IPO, including those who attend meetings with the issuer before the IPO.
- A greater risk of a conflict of interest arising for bookrunners as between issuers and investors when pricing and allocating an IPO, as the revenue from investors was much greater than the fees from the issuer, and that this could result in under-pricing of the IPO.
- Bookrunners being unsuccessful in anticipating which investors were long-term holders versus short-term traders.
In October 2016, the FCA repeated its findings from Occasional Paper 15 in its Final Report – Investment and corporate banking market study (MS15/1.3) and, following consultation with industry, ultimately did not propose new rules to regulate the area of IPO allocations, given the existing guidance it had in SYSC 10 (Senior Management Arrangements, Systems and Controls standards in the FCA handbook) and the upcoming (at the time) implementation of MiFID II, which would address a number of the issues raised. The FCA did note that it would conduct targeted supervisory work in the lead-up to MiFID II, focusing on specific issues identified at particular banks as part of its investigation.
THE EUROPEAN APPROACH – MIFID II
The original EU MiFID primarily governed the provision of investment services in financial instruments by banks and investment firms, and operation of traditional stock exchanges and alternative trading venues. MiFID II reinforces and enhances the provisions under the original directive and came into force on 3 January 2018.
The allocation process is primarily addressed through the conflicts of interest provisions of MiFID II and the MiFID II regulations (in particular, Articles 38 to 43 of the MiFID II implementing regulations), which set out additional conflicts requirements/processes for firms offering corporate finance services, such as underwriting, pricing or placing of securities.
Key requirements for such firms under MiFID II include:
- Before accepting a mandate, firms must have in place arrangements to inform the issuer client of a number of items including (but not limited to):
- timing and process with regarding to pricing/placing of the offering;
- details of targeted investors;
- the firm's arrangements to prevent or manage conflicts of interest that may arise where the firm places the relevant financial instruments with its clients or with its own proprietary book.
- Firms to identify and have in place processes for identifying all potential conflicts of interest arising from other activities of the investment firm. Where a firm cannot manage a conflict of interest through appropriate procedures, the firm shall not engage in the mandate.
- Firms shall have in place systems, controls and procedures to identify and prevent or manage conflicts of interest that arise in relation to possible under-pricing or over-pricing of an issue or involvement of relevant parties in the process. In particular, firms shall, as a minimum requirement, establish, implement and maintain internal arrangements to ensure both of the following:
- that the pricing of the offer does not promote the interests of other clients or the firm's own interests in a way that may conflict with the issuer client's interests; and
- the prevention or management of a situation where persons responsible for providing services to the firm's investment clients are directly involved in decisions on pricing to the issuer client.
- Firms shall provide clients with information about how the recommendation on the price of the offering and the timings involved is determined.
- Firms placing financial instruments shall establish, implement and maintain effective arrangements to prevent recommendations on placing from being inappropriately influenced by any existing or future relationships.
- The following practices are not consistent with the requirements on third-party payments or benefits when allocating financial instruments:
- an allocation made to incentivise the payment of disproportionately high fees for unrelated services provided by the investment firm ('laddering');
- an allocation made to a senior executive or a corporate officer of an existing or potential issuer client, in consideration for the future or past award of corporate finance business ('spinning'); and
- an allocation that is expressly or implicitly conditional on the receipt of future orders or the purchase of any other service from the firm by a client, or any entity of which the investor is a corporate officer.
- Firms shall establish, implement and maintain an allocation policy that sets out the process for developing allocation recommendations. The allocation policy shall be provided to the issuer client before agreeing to undertake any placing services. The policy shall set out the relevant information available at that stage about the proposed allocation methodology for the issue.
- Firms shall involve the issuer client in discussions about the placing process, in order for the firm to be able to understand and take into account the client's interests and objectives. The investment firm shall obtain the issuer client's agreement to its proposed allocation per type of client for the transaction according to the allocation policy.
- Firms shall keep records of the content and timing of instructions received from clients. A record of the allocation decisions taken for each operation shall be kept, to provide for a complete audit trail between the movements registered in clients' accounts and the instructions received by the investment firm. In particular, the final allocation made to each investment client shall be clearly justified and recorded. The complete audit trail of the material steps in the underwriting and placing process shall be made available to competent authorities upon request.
WHAT MIGHT ASIC DO?
While it is unclear at present what (if anything) will come of ASIC's allocations project, and notwithstanding that equity capital market practices vary between jurisdictions, it is possible that ASIC's review and findings may be similar to that the FCA found in its Occasional Paper 15 (as outlined above). Although the FCA ultimately decided that it did not need to change the existing regulatory regime, this was partly due to the fact that the new MiFID II regime was shortly coming into force, which addressed a number of the issues it had identified.
What is clear is that ASIC has already flagged it will be consulting with its international counterparts on the issue, and it is very likely that for guidance it will look closely at the position adopted in the UK / Europe. This would be consistent with how the new proposed product design and distribution bill (see our Client Update: Design and distribution of financial products – regulating 'retail product distribution conduct') currently being consulted on has been influenced by the equivalent European product governance rules.
As it relates to allocations, while there are general conflict of interest obligations that are applicable to AFSL licensees, the European approach has been to deal with the issue through express obligations, and to codify obligations, conduct and certain practices relating to the provision of underwriting services and the allocation of securities, as a means of managing conflicts of interest in the process.
Could this be where ASIC ends up on the issue? Time will tell, but there may be some merit in Australian lead managers/underwriters considering their own internal practices and processes as they relate to allocations and conflicts of interest; and looking at them through the regulatory prism that applies to their European counterparts2, to see if there are any areas where current practices/processes could fall short of those requirements, and to consider if any improvements could be made.
Footnotes
- This review covered companies listing on most European exchanges and companies from across Europe, Africa and the Middle East. The FCA also reviewed IPOs with a primary listing in the UK in conjunction with trading data.
- This may already be underway for those investment banks that are subsidiaries or branches of European based entities.
For further information, please contact:
Julian Donnan, Partner, Allens Linklaters
julian.donnan@allens.com.au
