ESMA focuses on marketing and sale of fractional shares

RegCORE Client Alert | Capital Markets Union

QuickTake

Investing in fractional shares has gained considerable popularity in the past decade. This is particularly the case as fractional shares are a form of investment whereby (usually retail client) investors can purchase a fraction of single share (or other financial instrument) by paying only a proportional amount of the purchase price. Fractional shares usually allow the investor the right to receive the economic benefits stemming from dividends but normally do not carry voting rights. Investments in fractional shares have led to greater retail market participation. While greater retail market participation is welcome, the marketing and sale of fractional shares needs to comply with relevant requirements.

On 28 March 2023, the European Securities and Markets Authority (ESMA) published a short 2-page Public StatementAvailable here.Show Footnote “on derivatives on fractions of shares”. Specifically, the Public Statement clarifies that derivative products based on a fraction of shares cannot be considered to be equivalent to actual corporate shares.ESMA is unequivocal on this point by stating: “Derivatives on fractions of shares are not corporate shares. No client information on these instruments, including marketing communications, shall therefore suggest to a client that he or she is being offered a fraction of a corporate share.”
And that:
“As derivatives on fractions of shares are not corporate shares, firms should not use the term fractional shares when referring to these instruments. ESMA would deem such use of the term misleading and therefore in breach of MiFID II requirements.”Show Footnote Consequently, the Public Statement is clear that firms must not use the term “fractional shares” when advertising such products. Moreover, ESMA is clear that firms must ensure clients are reasonably able to comprehend the respective nature and risks associated with particular financial instruments and that the prospective investor is purchasing a derivatives product.

The Public Statement sets out ESMA’s and the national competent authorities’ (NCAs) supervisory expectations on the topic and thus serves to ensure effective and consistent application of relevant regulatory requirements applicable to fractional shares and to foster convergence in supervisory outcomes expected of relevant firms.

This Client Alert from PwC Legal’s EU RegCORE looks at some of the key legal and regulatory points regulated firms should consider when providing services on investing into fractional shares. It is very conceivable that ESMA and NCAs will continue monitoring this development and may undertake further steps to ensure that fractional shares is provided in a manner that is consistent and applicable with MiFID II’s requirements and that investment services continue to be provided in the best interests of the client. As a short-term priority, firms will need to update their client facing contractual and non-contractual documentation.

Key principles

Aside from ESMA requiring firms to refrain using the term “fractional shares” but instead to inform investors, in good time, that they are purchasing a derivative product, ESMA reminds of the need of investors to ensure a clear understanding of the nature and risks associated with such product. ESMA also reminds regulated entities that these products are complex and not suitable for all clients, but only for a limited audience, and as such require an appropriateness assessment where services are provided to retail clients.

Moreover, ESMA stresses that companies offering derivative products on fractional shares must fully disclose all direct and indirect costs and fees associated with the products and services offered. This includes expenses and fees related to the creation of fractional shares, as well as mark-ups and mark-downs, proportionally calculated based on the market value of the corresponding corporate share.

ESMA requires companies offering trading on these specific derivatives to implement additional protective measures, including clear explanations of the product, its costs, management, and target audience, to safeguard retail investors.

ESMA stresses that all information provided to clients regarding these instruments should be fair, clear, and not misleading, and that firms must transparently disclose all direct and indirect costs and charges associated with them.

As complex products under product governance rules, fractional shares, as derivatives, require a detailed identification of the target market, considering factors such as counterparty and liquidity risks. This will likely result in a narrower target market.

Due to the complexity of derivatives, an appropriateness assessment is necessary when providing non-advised services to clients. Pursuant to the EU’s MiFIR/MiFID II regime the appropriateness test is not necessary when the investment relates to non-complex instruments, such as for instance shares listed on a regulated market. These orders can be processed on an “execution only” basis. However, ESMA clarifies that transactions on fractional shares cannot be settled on an “execution only” basis given the complex nature of the derivatives even where the transactions in the underlying shares could potentially benefit from that regime. Accordingly, while the appropriateness test is likely to apply, that assessment is a separate requirement that does not exempt the relevant firm from conducting a suitability assessment if such firm provides investment advice and/or portfolio management services.

If derivatives on fractions of shares are packaged retail and insurance-based investment products (PRIIPs), firms must comply with the PRIIPs Regulation and provide retail clients with a PRIIPs Key Information Document (KID). The objective of the KID is to help investors understand and compare the key features and associated risks of these products.See Regulation (EU) No 1286/2014, available here. Firms producing or selling investment products are obliged to provide retail investors with a KID regarding the product intended to be sold. These must be provided to retail investors before any agreement is made and should be a maximum of three pages long. More specifically, KIDs must include:
•    The name of the product and the identity of the producer;
•    The types of investors for whom the product is intended;
•    The risk and reward profile of the financial product, including a summary risk indicator, possible maximum loss of invested capital and appropriate performance scenarios of the product;
•    The costs associated with the investment in the financial product to be borne by the investor;
•    Information on complaints procedures.Show Footnote

Next steps

ESMA’s Public Statement packs a bit of a punch in terms of a number of legal and regulatory priorities.  These include some of the following immediate steps:

1. Relevant firms involved in fractional shares investing using derivatives will need to revise their marketing but also contractual materials to align them with ESMA's new supervisory expectations.
2. Any mention of “fractional shares” in relation to these derivatives must be removed, and investors must be provided with clear and comprehensive information on the costs and charges imposed by the investment firm.
3. While ESMA’s statement does not explicitly prohibit offering derivatives on fractions of shares, it may impose effective restrictions on the offering and/or marketing of these products due to the heightened product governance standards and the obligation to conduct an appropriateness test for all client transactions.
4. For fractional shares not marketed through derivatives, the Public Statement clarifies that these alternative structures must also be described and disclosed clearly, fairly, and comprehensively. However, the ban on the term “fractional shares” and the same requirements related to product governance, appropriateness tests as well as publishing a KID are not explicitly imposed for such non-derivatives based fractional shares. It remains to be seen if relevant firms will restructure their fractional shares schemes and utilise different contractual arrangements to mitigate the impact of ESMA’s Public Statement.

Outlook

It is likely that further supervisory guidance in this area, including as a result of the EU’s Retail Investment Strategy package of reforms, will be forthcoming on the topic of fractional shares. That being said, there are a number of legal and regulatory, along with other challenges that those wishing to comply with the Public Statement may be faced with, in particular:

1. Compliance costs: Adhering to the new guidelines in the Public Statement may require significant changes to processes as well as to client-facing documentation as well as agreements;
2. Reputational risks: Failure to comply with the Public Statement can result in reputational damage, fines, or even license revocation; and
3. Shift in business models: Some brokers may need or otherwise chose to move away from offering fractional share trading services or make changes to their business models to align with the new regulatory framework. Smaller brokers may find it challenging to keep up with the costs and complexities of compliance, leading them to exit the market or merge with larger firms. This consolidation could result in a more stable and reliable industry but may also limit investor choice and stifle innovation.

In conclusion, to ensure that fractional share trading abides by the relevant criteria and that investment services continually prioritise clients’ best interests, ESMA and NCAs will continue to monitor the industry’s progress and may take more measures in the future if necessary, including potentially for certain asset classes.

About us

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If you would like to discuss any of the developments mentioned above, or how they may affect your business more generally, please contact any of our key contacts or PwC Legal’s RegCORE Team via de_regcore@pwc.com or our website or further analysis (in German) from our Risk & Regulation colleagues from PwC Germany.