Investing in complex financial instruments

Following the Company Announcement and Formal Notice by Bank of Valletta plc as well as my article titled “A bond partially by ballot” explaining certain features of the new BOV subordinated note issue that make it a complex financial instrument, many people have been asking about the procedure for applying for some of these bonds and who can assist them in the process.

This article is intended to explain the requirements and procedures necessary to invest in complex financial instruments.

As a start, it is worth highlighting that apart from this new BOV bond issue, there are various other subordinated bonds already listed on the Malta Stock Exchange both of BOV as well as other banks such as HSBC Bank Malta plc and Mediterranean Bank plc. The subordinated nature of these bonds also classify them as complex financial instruments.

Moreover, it is important for investors to understand that not only subordinated bonds are classified as complex financial instruments but also other types of bonds and instruments.

In its opinion paper published in February 2014, the European Securities and Markets Authority (ESMA) had explained that complex instruments also include callable bonds. For investors mainly focusing on the local market, it is worth highlighting that there are several callable bonds currently listed on the Malta Stock Exchange since in the past years many companies opted to issue bonds with an early repayment option. These are also complex instruments.

Furthermore, investors who also invest across international financial markets, should note that ESMA classify exchangeable bonds, convertible bonds and perpetual bonds also among the list of complex financial instruments. In fact, many bonds across international financial markets have such features and therefore many investors have been investing and are already exposed to various complex instruments.

However, the degree of complexity varies across different instruments and since many instruments have different features and structures, these would affect the intrinsic level of risk. As an example, the complexity of a callable bond that can be redeemed 2 years prior to the final maturity date cannot be compared to a convertible or a perpetual bond. As such, the MFSA had indicated in a circular in March 2014 that it does not necessarily follow that a person who has the knowledge and experience to invest in callable bonds also has sufficient knowledge to invest in perpetual bonds. The features making the instrument a complex one differ from one instrument to another and one needs to be comfortable with the salient features of the particular financial instrument.

Moreover, by way of clarification, ordinary shares listed on a regulated market (such as the MSE) and bonds without a callable feature (sometimes referred to as bullet bonds) are classified as non-complex instruments. These type of bonds are the ones that are now more commonly being issued in Malta.

So what is the procedure for investors who wish to apply for these BOV subordinated notes?

As indicated last week, the first tranche of the BOV subordinated debt issuance programme is split into two different series. Series 1 applies to investors subscribing for a minimum of €25,000 while under Series 2, investors may apply for a minimum of €5,000.

Under Series 1 (minimum €25,000), applicants interested in applying without seeking advice must undergo an appropriateness assessment. On the other hand, should an applicant seek investment advice or portfolio management services from a licence holder, then a suitability assessment is necessary.

Under Series 2 (minimum €5,000), all applicants must seek advice and must undergo a suitability assessment. This series cannot be applied for by anyone who does not seek advice.

In terms of MFSA rules, an appropriateness test is to be carried out by licence holders to assess whether the investor possesses the necessary knowledge and experience to invest in the proposed instrument and to understand its features and risks. In this case, applicants will be asked to provide certain information including their level of education, their knowledge of bond markets and the features of subordinated debt and their experience in investing in similar complex instruments.

When providing investment advice or a discretionary portfolio management service (where the licence holder has been mandated by the investor to invest at his discretion on his/her behalf), an investment services licence holder must assess whether the instrument is indeed suitable for that particular client. This assessment of suitability, which is also a requirement on licence holders in terms of MFSA rules to enable the licence holder to act in the client’s best interests, entails understanding the person’s knowledge and experience in relation to the instrument being discussed as well as the person’s financial background and investment objectives. In this case, applicants will be asked for the same information required for the appropriateness assessment as well as additional information on their investment objective, risk apetite, investment horizon and also a summary of their financial standing (including values of their assets, liabilities and average level of income).

On 4 November, the MFSA issued a circular to investment services licence holders, which is also available on their website, reinforcing the importance of the appropriateness and suitability assessments, particularly in the case of complex instruments and highlighting best practice in this respect such as the requirement to elicit clear answers from clients in respect of the investment’s features.

Furthermore, the MFSA stipulates that a licence holder that carries out a suitability or appropriateness test must ensure that the investor understands the particular features of the instrument or product by providing “clear answers from specific questions presented to the client about the product features in order to confirm that the client is effectively aware of the features and risk of the product or instrument in question”.

The MFSA also imposed an additional requirement that such assessments of appropriateness and suitability of investments need to be signed by the client.

Unfortunately, not all investors seem to understand this obligation and many people who have called telephonically requesting information on the BOV offer were surprised at the level of information that financial intermediaries will need especially given the requirement to answer a number of questions regarding the subordinated nature of these bonds and the understanding of the bail-in mechanism. It is important for investors to recognize that without this information financial intermediaries cannot  perform the duties expected of them by the regulators to be in a position to assist clients in their investment decisions.

In this circular, the MFSA reiterated that financial intermediaries “are required to ensure that clients are given all the relevant information in non-technical jargon such that clients are in a position to make an informed decision with respect to their investment options”.

My article of last week was intended to assist in this respect and educate the retail investor accordingly. However, certain terms such as “subordination” and “bail-ins” are technical in nature and would still need to feature during discussions with clients.

As such, investors must be aware that when applying for the BOV subordinated notes on offer, there is this question and answer test that they will be asked to undergo.

Finally, investors must also be aware that the application procedure for new investments has become a relationship-based service between the investor and the financial intermediary. Long gone are the days where an application form to participate in general public offerings could simply be completed, signed and submitted by mail.

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