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:
- equity linked bonds on several levels of capital protection;
- 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
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.
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.
ii LEGAL AND REGULATORY FRAMEWORK
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 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 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.
iii OFFERING PROCESS AND POST-SALE REQUIREMENTS
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.
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 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.
iv EXCHANGE LISTING AND TRADING
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.
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.
v TAX CONSIDERATIONS
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.
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.
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.
vii OUTLOOK AND CONCLUSIONS
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.
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.
5 Regulation (EU) 2017/1129, June 2017.
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).
12 ESMA35-43-620 FI, 5 February 2018.
13 ESMA/2015/1783, 26 November 2015.