Historically, due to certain restrictions under US securities laws, equity securities of US companies and other companies that do not qualify as “foreign private issuers” under US securities laws (collectively, “US-Based Issuers”) that are offered and sold outside the United States in reliance on Regulation S (“Regulation S”) under the US Securities Act of 1933 (the “Securities Act”) are generally not eligible for electronic settlement in the CREST system (“CREST”) operated by Euroclear UK & Ireland (“EUI”), which is the principal central securities depository (“CSD”) for transactions on the London Stock Exchange (the “LSE”), until at least the expiration of a one-year “distribution compliance period” (the “Distribution Compliance Period”). Accordingly, US-Based Issuers applying to have such securities admitted to trading on UK markets must currently request a derogation from the rules of the LSE 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.
However, as we previously wrote in November 2014, under Article 3(2) of the EU Regulation on Central Securities Depositories (“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 on or before the intended settlement date. All transactions executed on 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.
On 11 May 2015 the LSE issued Market Notice N09/15, which provides that order book trades in equity securities of US-Based Issuers that are offered and sold outside the United States in reliance on Regulation S (“Regulation S Category 3 securities”) must be settled electronically beginning on 1 September 2015, and EUI published a whitebook (the “Whitebook”) relating to its proposed “Euroclear UK & Ireland: Regulation S Category 3 Settlement Service” (the “Electronic Settlement Service”), for consultation.
The proposed Electronic Settlement Service would, including during the Distribution Compliance Period, provide EUI clients with access to full electronic settlement in CREST of Regulation S Category 3 securities and, if applicable, equity securities of US-Based Issuers subject to transfer restrictions in connection with offers or sales in reliance on Rule 144A (“Rule 144A”) under the Securities Act (collectively, “Restricted Securities”), and is intended to facilitate compliance with both Article 3(2) of CSDR and the US securities law restrictions applicable to Restricted Securities.
In order to facilitate compliance with applicable US securities law restrictions relating to Restricted Securities, the Electronic Settlement Service would amend the current CREST system to provide: (a) appropriate identifiers in the security type, security abbreviation and security description fields which identify whether the security is a Regulation S Category 3 security or Regulation S Category 3 security/Rule 144A security; (b) access to the text of the restrictive legends and restrictions applicable to such Restricted Securities under Regulation S and, as applicable, Rule 144A, which legends and restrictions CREST members (such as brokers, banks, custodians and investment houses) participating in certain transactions in Restricted Securities (essentially, transactions which may result in the transfer of legal ownership of the Restricted Security) would be required to read; and (c) validation which would prevent the settlement of such transactions in Restricted Securities unless the CREST member proposing to acquire the Restricted Security provides certain certifications relating to applicable US securities laws. Where a CREST member wanted to receive Restricted Securities on behalf of another person (such as one of its clients), it would be required to ensure that the status of that other person and the circumstances of the transaction are such that the CREST member is permitted to receive the Restricted Securities on the other person’s behalf and is capable of giving the certifications required in order for the transaction to settle. In addition, CREST members would be required to put in place adequate arrangements (such as collecting paper certificates from their clients) to comply with restrictions applicable to Restricted Securities in respect of transactions that settle solely on the CREST member’s own books, without any movement of the Restricted Securities in the CREST system.
Under the proposed Electronic Settlement Service, once any applicable Distribution Compliance Period comes to an end, and the applicable security is not subject to any other transfer restrictions under the Securities Act, a US-Based Issuer would be able to provide confirmation thereof to the LSE and EUI, at which time such security would cease to be a Restricted Security and would be able to be held and transferred through CREST in the same manner as any other security.
As shares of companies that are not incorporated in the United Kingdom or Ireland currently may not settle directly in CREST, Restricted Securities would be admitted to the CREST system as depository interests representing such Restricted Securities.
Settlement of transactions in Restricted Securities through the Electronic Settlement Service would be conducted on a ‘T+2’ basis. This would be significantly shorter than the ‘T+10’ settlement period mentioned above, which should result in a reduction of CREST members’ operational risks and liquidity requirements with respect to Restricted Securities.
The Electronic Settlement Service would not be available all people. Specifically, as a result of restrictions relating to Regulation S Category 3 securities, the Electronic Settlement Service would not be available to affiliates (as defined in Rule 405 under the Securities Act) of the applicable US-Based Issuer. In addition, because EUI is not registered, or exempt from registration, as a clearing agency in the United States, the Electronic Settlement Service would also not be made available to CREST participants or prospective CREST participants that are: (a) natural persons with US residences; (b) companies whose registered offices, principal places of business or executive offices are located in the United States (including non-US branches thereof); (c) US banks (and any non-US branches thereof); or (d) broker-dealers registered with the US Securities and Exchange Commission (even if such broker-dealers do not have a US residence). It should also be noted that, although the Electronic Settlement Service would provide a means to facilitate compliance with the applicable US securities law restrictions relating to Restricted Securities, it would remain the responsibility of individual CREST members and US-Based Issuers to satisfy themselves (after consultation with their advisors) that such means are sufficient, in their individual circumstances, to comply with those restrictions.
It is hoped that EUI’s proposed Electronic Settlement Service will result in a significant change in market participants’ views of, and ability to have, Regulation S Category 3 securities listed on the AIM market of the LSE and the LSE’s Official List. Specifically, if EUI’s proposed Electronic Settlement Service is adopted and 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.
The consultation with respect to the Whitebook, and the related changes to the CREST system, will close on 10 June 2015. We will provide updates regarding EUI’s proposed Electronic Settlement Service, 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 Restricted 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).