Risk Factor Disclosure

Definition

Risk Factor Disclosure is the practice of communicating (in formal documentation to external parties, e.g a prospectus) a list of risk factors associated with a certain product or service, in particular in the financial services industry

The purpose of including risk factors in a prospectus or other formal financial document is to ensure that investors or other counterparties can assess the risks related to their investment / relation, therefore allowing them to make informed decisions. The appropriate disclosure of risk factors is essential for mitigating Legal Risk

A risk factor disclosure may be public or private to the clients / counteparties involved

Best Practises

Best practices and regulations around risk factor disclosures vary considerably based on

• jurisdiction
• type of financial product
• nature of client / counterparty

This variety does not support detailed enumeration of what entails best practice. The high level principles are:

• Clear communication of the materiality and specificity of risk factors including corroborating evidence and impact analysis (where possible)
• Effective presentation of the nature of risk factors, using a suitable number of categories and subcategories and concise language
• Ensuring the inclusion of Mitigating Factors and Disclaimers does not obscure the true nature of the risk

ESMA Guidelines on Risk Factor Disclosure

The following list covers key principles of the ESMA Guidelines on risk factor disclosure

Materiality of Risk Factors

The materiality should be apparent from the disclosure of the risk factor. The materiality assessment of risks remains the responsibility of the issuer who should ensure that the disclosure of the risk factor clearly demonstrates that the risk is material.

Specificity of Risk Factors

A risk factor should identify and disclose a risk that is relevant to the issuer/guarantor or the securities concerned rather than simply comprising of generic disclosure. Specificity establishes a clear and direct link between the risk factor and the issuer guarantor or securities.

Specificity related to the issuer/guarantor may depend on the type of entity (e.g. start-up companies, regulated entities, specialist issuers, etc.) and specificity related to the type of security may depend on the characteristics of the security.

Disclosure of risk factors should reflect interdependencies that risk factors may have, e.g. that the risk associated with a security may be higher or lower depending on the financial condition of the issuer or the credit quality of a pool of assets underlying a series of notes.

Corroborating the Materiality and Specificity of Risk Factors

Direct/clear corroboration of the materiality and specificity of the risk factor is normally demonstrated via the inclusion of specific corresponding information elsewhere in a prospectus. In certain cases, it is sufficient that materiality and specificity of risk factors is identifiable by reference to the overall picture of the issuer/guarantor and the securities presented in the prospectus.

Disclosing the Impact of Risk Factors

Providing quantitative information within the disclosure of risk factors helps to demonstrate the materiality of a specific risk factor. Such information may be available in previously published documents such as management reports, Financial Statements or other ad-hoc-disclosures

Alternatively, where quantitative information is not available or where it is not appropriate to include such information in the prospectus, the description of the potential negative impact of the risk factors should be described using a qualitative approach.

One option for the presentation of the materiality of risk factors may be by reference to the scale of low, medium or high (as per the penultimate paragraph of Article 16(1) of the Prospectus Regulation).

Presentation of Risk Factors

Suitable Categorization

The presentation of risk factors across categories (depending on their nature) should aid investors in navigating the risk factors present. Such categorisation of risk factors and the ordering of risk factors within each category should support their comprehensibility. Both should assist investors in understanding the source and nature of each disclosed risk factor. A risk factor should only appear once, in the most appropriate category.

Category headings should reflect the nature of the risk factors. When presenting category headings it should be ensured that they are easily identifiable in the prospectus, through the use of appropriate spacing and bold font

A category should not be included when it is not relevant. Where risk factors are similar in nature, they can be arranged and presented under the same heading

Ranking by Materiality

The most material risk factors have to be presented first in each category, but it is not mandatory for all the remaining risk factors within each category to be ranked in order of their materiality

Appropriate Number of Categories

The number of categories and sub-categories included in the prospectus should not be disproportionate to the size/complexity of the transaction and risk to the issuer/guarantor

Multi-product base prospectuses to be an example where further categories/sub-categories may be appropriate.

Separation into Subcategories

Sub-categories should only be used where their inclusion can be justified based on the particular circumstances of the case. For example, in the case of a base prospectus containing multiple types of securities, sub-categories might be necessary for the presentation of risk factors

Conciseness

The disclosure of each risk factor should be presented in a concise form. The ‘size inflation’ of prospectuses, a phenomenon which may also be directly attributable to the inclusion of large quantities of information surrounding each risk factor included in a prospectus, may obscure the comprehensibility of a prospectus.

Disclosure of Risk Factor Mitigation

Mitigating language is not prohibited. Where mitigating language is included in relation to a risk factor, it can only be used to illustrate probability of occurrence or expected magnitude of negative impact. Excessive or inappropriate use of mitigating should be avoided. Such mitigating language could limit a reader’s perception of the true extent of a risk factor’s negative impact or of its probability of occurrence, to the point that the reader is no longer clear whether there is any remaining material risk.

Role of Disclaimers

Disclaimers may obscure the specificity and materiality of a risk factor and/or other risks that the issuer/guarantor is exposed to, as they often only contain generic language and do not provide clear descriptions of the specificity of the risks.

Risk factors should not only serve the purpose of shielding persons responsible for the prospectus from liability. Risk factor disclosure that serves only as a disclaimer is not typically issuer, guarantor or security specific

Risk factors should not merely be copied from other documents published by other issuers or previously by the same issuer if they are not relevant to the issuer/guarantor and/or the securities.

Disclaimer

• Refer to the ESMA document for the actual guidelines in the context of the EU Prospectus regulation