Since the Markets in Financial Instruments Directive (“MiFID”) came into force in 2007, European legislators and market participants have sought to harmonise the diverging European securities settlement framework, with a view to improving liquidity. The Regulation on Central Securities Depositories (“CSDR”), due to come into effect from January 2015, will create a common regulatory framework for securities settlement across the European Union. CSDR mandates the introduction of a shorter, harmonised, ‘T+2’ settlement cycle (with securities transactions to settle two business days after the trade date, rather than the current three business days in the United Kingdom and elsewhere). In addition, under Article 3(2) of CSDR, where a transaction in transferable securities takes place on a trading venue, the relevant securities must be recorded in book-entry form in a Central Securities Depository (“CSD”) on or before the intended settlement date. This means that all transferable securities, including those of issuers established in countries that are not an EU member state, are subject to this requirement, to the extent that the settlement of transactions in such securities is governed by the laws of an EU member state. Accordingly, all transactions executed on the London Stock Exchange (the “LSE”) will be subject to this requirement, irrespective of whether the relevant security is currently eligible for electronic settlement or not and regardless of the issuer’s jurisdiction of organisation.
It is hoped that Article 3(2) of CSDR will have a positive effect on the ease with which US issuers and other issuers that do not qualify as “foreign private issuers” under US securities laws (collectively, “US-Based Issuers”) are able to list on UK markets. Although the UK Listing Authority’s Listing Rules and the LSE’s AIM Rules for Companies currently require securities to be eligible for electronic settlement, as described in greater detail below, equity securities that are offered and sold in reliance on Regulation S (“Regulation S”) under the US Securities Act of 1933 (the “Securities Act”) of US-Based Issuers (“Regulation S, Category 3 securities”) are not currently eligible for electronic settlement in the principal CSD for transactions on the LSE (Euroclear UK & Ireland’s CREST system (“CREST”)) until at least the expiration of a Regulation S “distribution compliance period”. Accordingly, US-Based Issuers applying to have their Regulation S, Category 3 securities admitted to trading on UK markets must currently request a derogation from the rules, which is typically granted without much argument, to allow such securities to settle outside of a CSD in certificated form. Such settlement outside of a CSD results in longer settlement periods (typically ‘T+10’) and can have a negative impact on the liquidity and trading prices of the relevant securities, which ultimately can make a UK listing less attractive to US-Based Issuers than it would be if such physical settlement was not necessary.
By way of background, Regulation S is a safe harbour that sets out when offers and sales of securities will be deemed to occur outside of the United States for the purposes of US securities laws. If an offer or sale of securities is deemed to occur outside of the United States, it will not be subject to the registration requirements of the Securities Act. All offers and sales of securities that are made in compliance with Regulation S must meet two general requirements. First, the offer and sale must be made in an “offshore transaction”, which broadly means that the offer and sale must not be made to a person in the United States. Second, there must be no “directed selling efforts” in the United States, which generally means that there must not be any activity undertaken for the purpose of, or that could reasonably be expected to have the effect of, conditioning the market in the United States for any of the securities being offered in reliance on Regulation S.
With respect to Regulation S, Category 3 securities, certain other requirements must also be met. For example, in order for offers and sales of Regulation S, Category 3 securities by an issuer, a distributor, any of their respective affiliates or any person acting on their behalf to comply with Regulation S, such securities must contain the restrictive legends specified in Regulation S and, if the offer or sale is made prior to the expiration of a one-year distribution compliance period (or a six-month distribution compliance period, if the issuer is required to file periodic reports with the US Securities and Exchange Commission (“SEC”)), the sale must not be made to a US person or for the account or benefit of a US person (other than a distributor) and the purchaser generally must: (i) certify that it is not a US person and is not acquiring such securities for the account or benefit of any US person (or that it is a US person that purchased securities in a transaction that did not require registration under the Securities Act); and (ii) agree (A) to resell such securities only in accordance with the provisions of Regulation S, pursuant to registration under the Securities Act or pursuant to an available exemption from registration; and (B) not to engage in hedging transactions with regard to such securities unless in compliance with the Securities Act.
Although the SEC has previously indicated that Regulation S, Category 3 securities need not be in certificated form, the procedures that would be necessary to allow both electronic settlement of such securities in CREST and compliance with the applicable provisions of Regulation S are not currently in place. As such, presently, the only practical way that an issuer of Regulation S, Category 3 securities can provide for electronic settlement in CREST is: (a) to wait until the expiration of the Regulation S distribution compliance period; (b) if the issuer is not incorporated in the United Kingdom or Ireland, set up depository interests representing its shares (as shares of companies that are not incorporated in the United Kingdom or Ireland currently may not settle directly in CREST); and (c) have non-affiliate holders request the dematerialisation of their shares and provide applicable certifications relating thereto.
One existing problem remains, which is that even after electronic settlement is established, if a US-Based Issuer subsequently raises additional funds through the sale of newly-issued Regulation S, Category 3 securities, those newly-issued securities will be subject to a new Regulation S distribution compliance period and will have to be held in certificated form until at least the expiration thereof. This results in a US-Based Issuer having two lines of listed stock, which can have an additional adverse effect on liquidity.
On 18 September 2014, the LSE issued a Market Notice announcing its intention to amend its rules, with effect from 5 January 2015, so that all “on LSE” transactions, including transactions in Regulation S, Category 3 securities prior to the expiration of the Regulation S distribution compliance period, are able to comply with the requirements of Article 3(2) of CSDR and settle electronically. The Market Notice also announced that the LSE would undertake a review of all settlement rules that relate to non-electronic settlement. The LSE has not yet, however, issued its proposed rule amendments.
As mentioned above, it is hoped that the changes mandated by CSDR will result in a significant change in market participants’ views of, and ability to have, Regulation S, Category 3 securities listed on AIM and the LSE’s Official List. Specifically, if the LSE, CREST, registrars and other market participants are successful in adopting new procedures that allow for electronic settlement of Regulation S, Category 3 securities in compliance with both CSDR and Regulation S, and such procedures are accepted in the marketplace, the current stigma with respect to such securities would likely be greatly reduced, which would make a UK flotation a more attractive option for US-Based Issuers.
We will provide updates regarding the LSE’s proposed rule amendments, as well as any other proposals from market participants that would allow for electronic settlement of Regulation S, Category 3 securities in compliance with both CSDR and Regulation S, as they become available. For further information, or for information regarding trading of Regulation S, Category 3 securities on the LSE generally, please contact Kate Francis (+44 (0)20 7031 3746, francis.kate dorsey.com), Max Beazley (+44 (0)20 7031 3704, beazley.max dorsey.com) or Brian Rosenau (+44 (0)20 7031 3760 or +1 (212) 415 9281, rosenau.brian dorsey.com).