Introduction
The European Securities and Markets Authority (ESMA) has released a Public Statement in response to concerns raised with respect to investor protection surrounding derivatives on the fraction of shares.
On 28 March 2023, the EU’s financial market regulator and supervisor highlighted that derivatives on fractions of shares do not constitute corporate shares, and therefore investment service providers should avoid using the term ‘‘fractional shares’’ when referring to such instruments.
Fractional Shares Overview
Fractional shares allow investors to participate in the share performance of an issuer, however at a lower purchase price, in proportion to the underlying share. These instruments track the share price and allow the investor to participate in the economic benefits stemming from dividends, nonetheless, they do not carry any voting rights.
From a commercial point of view, different structures may be described as fractional shares, nonetheless, the ESMA Statement focuses on derivatives which stem their value from the price of an underlying corporate share. To this effect, the EU regulator highlighted that the Statement does not pertain to products providing access to the fraction of shares, such as co-ownership structures.
Nevertheless, the Regulator stressed that other structures of fraction of shares raise investor protection concerns and that the Statement may be applicable for such structures.
Disclosure Requirements
Subsequently, investment service providers that offer such instruments are required to provide clients with a description of the nature and risks of the relevant financial instruments, as well as adequate marketing information in a fair, clear and non misleading manner.
Pursuant to the Statement, the EU regulator, expressly prohibits information including marketing communication to clients, that they are being offered a fraction of shares of a corporate share, as such use would be deemed misleading and therefore in breach of MiFID II requirements. The EU regulator in an amicable effort to protect investors, requires investment service providers that any disclosure shall be clear and in plain language, and therefore explain that the investors will be buying derivative instruments and clarify the differences between these derivatives and corporate shares and with respect to rights inherent to corporate shares (dividends, voting rights etc.) The Regulator further points out that the risks associated with these derivatives, such as liquidity risks and counterparty, must be disclosed to investors, as well as how an order of such derivative will be executed and how the execution price will be determined.
Moreover, firms must clearly disclose all direct and indirect costs and charges relating to these derivatives and the service providers, including structuring and other costs embedded in these derivatives, as well as mark-ups and mark-downs compared on a proportional basis, to the market price of the underlying corporate share. Furthermore, investment service providers, when providing non-advised services, an appropriateness assessment should be conducted due to the complexity of these financial instruments.
Finally, derivatives based on the fraction of shares that fall under the packaged retail and insurance -based investment, the PRIIPs Regulation shall be applicable and therefore firms need to provide retail clients with a PRIIPs Key Information Document (KID).
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