While the swirl of day-by-day posturing, partisan commentary, and reluctance of the UK and EU authorities to reveal their negotiating hands make it challenging to discern probable routes forward and plan accordingly, there is no reason why even a "hard Brexit" cannot encompass access to the single market for financial services companies.
It is just over 130 days since Britain voted to leave the European Union, and on 3 November the UK government lost the first round in its battle with the courts for the right to quit the EU without Parliament’s consent. In this LawFlash, we bring our readers up to date on Brexit generally and explore how the established EU concept of third country passporting for financial services firms could mitigate the adverse effects of any exit from the EU single market for London as a leading world financial centre.
UK Prime Minister Theresa May announced her intention on 2 October to give notice to quit the EU. In light of her subsequent comments on Brexit to the press, it is clear that the UK government will seek bullishly to negotiate as “new-look” and integrated a trade and services agreement as possible as well as a compromise on immigration that leaves the UK in "control" (a notably elastic term) of its borders.
In Ms. May's own words:
I want British business to be able to trade with the EU and operate within the EU, and EU businesses to be able to operate here in the UK.
One could say (with apologies to Charles Dickens) that Ms. May has “Great Brexpectations” for a constructive Brexit deal with the EU. That said, the EU's current stance takes a surprisingly hard line against any special deal for the UK.
There are three stages of Brexit, the first being the current one pending UK notice of its intention to withdraw (already dubbed "the phony war stage"). Stage two will begin when the government gives notice to the EU of its intention to exit the EU and begins the process of exiting. Stage two will be by far the most significant stage embodying the UK-EU negotiations for Brexit, which will shape UK-EU relations and Britain's post-Brexit future for decades to come. The timetable for that process is initially set at two years, but with power to extend. Strictly in terms of EU legality, stage three is when the exit process is complete and the UK is able to “go it alone” in negotiating its post-Brexit future with the rest of the world; however, the UK is understandably reluctant to wait for the actual exit before embarking on stage three, which will last for years, so will begin stage three early (or, at least, early in the eyes of the EU) once it has given notice to quit. The reality is that, overall, although an exit from the EU will be on a two year time frame, the entire process could last five to ten years.
Any Brexit deal will encompass a wide range of workstreams covering Britain's legal separation from the EU; a withdrawal agreement under which existing assets and liabilities will be allocated; a free trade agreement covering the UK's future relationship with the EU (EU-UK FTA); a transitional phase between Brexit and commencement of the EU-UK FTA; accession to full membership of the World Trade Organisation; new free trade agreements to replace those between the EU and 53 other countries; and cooperation in the realms of defence, foreign policy, and security. Negotiation of fair and mutual transitional arrangements will be key for the economies of the UK and the EU to avoid adverse results of the "cliff edge" variety upon the UK’s exit.
The UK government's plans to invoke Article 50 by the end of March 2017 in reliance on the Royal prerogative rather than Parliamentary authority is in disarray following a legal battle in the UK courts brought by those who argue that Article 50 should only be invoked with the consent of Parliament by statute (the case was actually brought by a fund manager, a hairdresser, and a pressure group called The People’s Challenge). On 3 November, the High Court of England and Wales ruled that the government does not have power under the Royal prerogative to invoke Article 50 without prior Parliamentary consent. The government will appeal against the ruling to the Supreme Court under a fast-track process whereby the appeal leap-frogs the Court of Appeal. If it falls to Parliament to decide whether to give notice to quit, it could vote not to exit by a simple majority, but that could provoke a constitutional crisis (even civil disorder) in light of the referendum result, or, more likely, ensure that the approval legislation, whilst endorsing the referendum result, contains provisions which seek to involve Parliament in the process going forward.
Once notice to quit has been given, the government intention is to introduce legislation to repeal the European Communities Act 1972 (somewhat jingoistically dubbed "the Great Repeal Bill"). The 1972 Act enshrines the supremacy of EU law in the national law of the UK. Ironically, the so-called Great Repeal Bill will not in fact repeal all EU law derived provisions, but instead entrench them for the time being by making clear that they continue to apply while providing for case-by-case repeal or amendment of specified measures over time.
There is a spectrum of possible outcomes of any Brexit deal, bookended by "hard Brexit" and "soft Brexit". However, neither of those terms can clearly be defined. Some define “hard Brexit” as rejecting privileged access to the EU single market in return for submitting to some EU laws and institutions, with a “soft Brexit” constituted by the “Norway model” of trade in goods and passporting in services throughout the European Economic Area (EEA) with all the costs and obligations of full EU membership, but no say in law making ("taxation without representation", to use an apposite American expression). However, whilst talk of the UK adopting the Norway model was the flavour of the day in the immediate aftermath of the vote, it is now axiomatic in the UK and EU that Brexit will not involve the Norway model whereby the UK would join Iceland, Liechtenstein, and Norway as a member of the EEA. The EU maintains that there is only one type of Brexit available to the UK, and that is a hard Brexit.
In our view, use of the "soft/hard" terminology is unhelpful as it postulates a false dichotomy between continued EU membership on the one hand and wholesale rejection of all trade with the EU on the other.
Imagine if the UK had never joined the European Economic Community (as it then was) and ask yourself whether it would be objectionable now for the UK to negotiate a deal with the EU on trade in goods and services—the answer from the UK and the EU would be a resounding "no". However, it takes “two to tango” in any negotiation, and the EU has responded to UK posturing equally aggressively, reminding the UK of the sacred four freedoms—in particular, free movement of people—that are the corollary of participation in the EU single market generally, including the single market for financial services. We consider that whatever the posturing, ultimately a compromise will be reached, and the basis for that compromise will be mutual self-interest. Put simply, it is in the interests of the economies of both Europe and the UK that London's centuries-old role as a leading global financial centre continues. Continental Europe will be aware that the UK economy is the world's fifth largest and the EU’s second largest and that London's standing and pedigree as a financial centre is beyond doubt (and, let us not forget, actually rose as a result of the UK retaining Sterling—against the prevailing run of play—by rejecting the Euro). In reality, economic considerations may be trumped by political ones which seek to maintain the cohesion of the EU.
There is no reason why a "hard Brexit" cannot encompass some access to the single market for financial services. Full control of the UK's borders is compatible with that aspiration, since the UK would remain in such control whilst at the same time choosing to cede access to the UK for qualifying individuals, exactly as the UK is in control of its borders already vis-à-vis non-EU countries. In September, Philip Hammond, Chancellor of the Exchequer, told the Economic Affairs Committee of the House of Lords that there would be no restrictions on "highly skilled" people in financial services after Brexit.
The City of London is one of the world’s leading financial centres, vying only with New York City for the top spot. As such, many financial services firms choose the UK to headquarter their businesses, anchoring themselves in a convenient time zone and location from which to access the European and global markets. Post-referendum, the primary concern of financial services professionals is whether they will be able to continue to access the European single market for financial services. This begs the question of whether the UK, in its Brexit trade deal negotiations, will accept the fundamental European principle of the free movement of people in order to gain such access.
The importance of the EU passport and access to the single market should not be underestimated. According to the European Banking Authority, there are more than 2,000 UK investment firms carrying on Markets in Financial Instruments Directive (MiFID) business which benefit from an outbound MiFID passport:
- Nearly 75% of all MiFID outbound passporting by firms across the EU is undertaken by UK firms into the EEA;
- 2,079 UK firms use the MiFID passport to access markets in other EU countries; and
- more than 50% of all investment firms authorised under MiFID are based in the UK.
In addition, the European Securities and Markets Authority’s (ESMA’s) opinion of 30 July 2015 on the functioning of the Alternative Investment Fund Managers Directive (AIFMD) passport noted that out of 7,868 AIFs notified for marketing in other EU member states, including sub-funds of umbrella AIFs, 63.8% of those (5,027 AIFs) were from the UK. In addition, out of the 1,777 non-EU AIFMs marketing AIFs in EU member states, 1,013 (57%) were marketing AIFs in the UK. The figures are clear—the UK generates a significant proportion of the EU’s MiFID and AIFMD passporting business. Conversely, the UK financial services sector benefits hugely from the EU passport and access to the single market. For completeness, passporting rights also exist under the Insurance Mediation Directive, Mortgage Credit Directive, Electronic Money Directive, Capital Requirements Directive and Solvency II. However, those directives are outside the scope of this article.
In a recent wider analysis by the UK Financial Conduct Authority (FCA) which took into account all the passporting directives, FCA found the following:
EU27 into UK
UK into EU27
Number of passports in total
Number of firms using passporting
Many firms hold more than one passport; hence, there are significantly more passports than firms.
The optimal outcome for UK financial services firms that wish to retain their current access to the single market in financial services would be a bespoke deal, but if not achievable, the third country passport can mitigate the issues arising from withdrawal of passporting rights.
Upon the UK’s withdrawal from the EU, the passporting regime will, broadly, cease to apply to UK-authorised firms. In other words, the following will be the case:
- Investment firms, banks, and fund managers will no longer be able to passport into, or establish branches in, the remaining EU member states.
- Firms will not be able to market Undertakings for Collective Investment in Transferable Securities (UCITS) and AIFs EU-wide on a passported basis.
- Firms will only be able to market AIFs EU-wide using local private placement regimes.
- Investment managers will need to acquire local authorizations to conduct investment activities in each EU member state in which they operate.
- Many investment firms, banks, and fund managers would need to consider whether to relocate their base of operations in an EU country while retaining a substantial UK foothold in order to retain the passport.
Options if the UK Does Not Negotiate Continuing Access to the Single Market
The EU has already recognised the concept of non-EU or third country access to the passport, provided that stringent (but, in our opinion, entirely achievable) conditions are met. The best current examples of that are the AIFMD, the European Market Infrastructure Regulation (EMIR), and to some extent, the Prospectus Directive. In addition, MiFID II—due to come into force in January 2018—provides for such access, albeit in the non-retail sector only. However, the UCITS regime does not envisage the extension of its regime to non-EU countries, as by definition UCITS and their managers must be domiciled in the EU.
AIFMD Third Country Passport
AIFMD contemplates that non-EU AIFMs in eligible third countries may benefit from the right to manage AIFs and/or market units or shares of AIFs throughout the EU with a passport. At present, no such passports have been granted. However, the process for doing so is well underway. Canada, Guernsey, Japan, Jersey, and Switzerland have recently been given a “favourable opinion” by the ESMA in its advice to the European Commission on the extension of the AIFMD passport. In addition, ESMA has given favourable but qualified opinions regarding the same in respect of Australia, Hong Kong, Singapore, and the United States, but has not yet been able to provide definitive advice in relation to Bermuda, the Cayman Islands, and the Isle of Man. The Commission is deliberating on the timing, and it is not clear when the third country passport will become available to AIFs and AIFMs based in a third country that has already been given a favourable opinion by ESMA.
If the UK were to leave its current AIFMD-compliant regime in place, it ought to be technically straightforward, following Brexit, for the AIFMD passport to be extended to the UK. If so, UK AIFMs managing EU AIFs and/or non-EU AIFs could become authorised under AIFMD by achieving authorised status in an EU country and could continue to use marketing and management passports subject to a positive opinion from ESMA and a decision by the Commission that the UK qualifies for such treatment under the applicable criteria. However, political considerations would be inherent within any such decision and would likely complicate it.
MiFID II Third Country Passport
The Markets in Financial Instruments Regulation (MiFIR), which is due to come into force in January 2018 (and forms part of the MiFID II regime), entitles “third country” investment firms to provide investment services only to professional clients across the EU upon registration with ESMA. Registration will be contingent upon a range of conditions, including a decision made by the Commission that the relevant third country's prudential and business conduct framework is equivalent to EU standards.
Would the UK pass the third country test?
In our opinion, yes. On 24 June, the FCA made it clear that firms are to continue down the road to implementation and are to comply with all EU legislation until further notice. As such, if the UK implements in full the provisions of MiFID II, it ought to be a relatively simple process, following Brexit, for the MiFID II passport to be extended to the UK, thus providing firms with non-retail single market access. However, political considerations could trump that.
EMIR Third Country Passport
EMIR is the product of an international initiative of the G20 developed in the wake of the Great Recession. With this in mind, the UK is unlikely to want to unravel EMIR post-Brexit. Since in a post-Brexit world a UK undertaking would no longer be established in the EU, under EMIR, UK undertakings that are currently financial counterparties or non-financial counterparties would become third country entities (TCEs) for EMIR purposes and no longer directly subject to EMIR. However, EMIR does impact TCEs when they trade with EU counterparties, and to that extent EMIR will continue to impact same post-Brexit.
The City of London boasts some of the world’s largest clearing houses, and at least three of them are currently permitted under EMIR to provide clearing services to clearing members and trading venues throughout the EU in their capacity as ESMA-authorised central counterparties (CCPs). Post-Brexit, however, a UK CCP would become a third country CCP. Under EMIR, a third country CCP can only provide clearing services to clearing members or trading venues established in the EU where that CCP is specifically recognised by ESMA. This would require, among other things, clearing houses operating out of London to apply to ESMA for recognition, the Commission to pass an implementing act on the equivalence of the UK’s regime to EMIR, and relevant cooperation arrangements to be put in place between the EU and the UK—a lengthy process overall and one thrown into doubt by Brexit.
Encouragingly for the UK, since 27 April 2015, 19 third country CCPs have been recognised by ESMA emanating from Australia, Canada, Japan, Hong Kong, Mexico, Singapore, South Africa, South Korea, Switzerland, and most recently the United States. Clearly, there is an appetite within ESMA and the EU for third country CCPs to provide services within the EU, and post-Brexit, we believe that financial institutions based in the EU will certainly want to continue to access UK regulated markets and CCPs.
Prospectus Directive Third Country Passport
As an EU member state, the UK is currently a participant in the Prospectus Directive’s passporting regime for prospectuses. Any failure by the UK to secure continued access to the single market would bring challenges. Notably, prospectuses approved in an EU member state in connection with a listing on a regulated market in that member state would need to be recognised by the FCA in order to be approved for UK listing purposes. Conversely, prospectuses approved in the UK would need to be approved afresh by the regulatory authority in an EU member state under applicable Prospectus Directive standards for the prospectus to be used for a listing on a regulated market in that state.
However, under the Prospectus Directive, an EU member state regulator is able to approve a prospectus approved in a “third country” if the Commission is satisfied that the prospectus was drawn up in accordance with international standards, and that the relevant third country’s prospectus content requirements were equivalent to those in the Prospectus Directive. Provided the UK’s prospectus requirements do not change dramatically from what are currently in place, we believe that the UK’s requirements should be considered equivalent to the Prospectus Directive requirements for the purposes of listing in the EU.
UCITS funds and their managers (but not necessarily the delegates of their managers), by definition, must be domiciled in the EU. Unlike AIFMD, EMIR, MiFID II and the Prospectus Directive, the UCITS regime does not envisage the extension of its regime to non-EU countries. In other words, UK UCITS funds would no longer qualify as UCITS. Instead, UCITS would become AIFs. This means that UK-based UCITS funds would no longer be automatically marketable to the public in the EU and would therefore become subject to local private placement regimes. Conversely, a UCITS fund established, say, in Ireland or Luxembourg, would no longer be marketable in the UK to the general public, and a management company based in Ireland or Dublin would no longer be entitled to provide management services to a UK-based UCITS fund.
During any Brexit negotiations, insertion of a “third country” equivalence test into the UCITS regime may be used as leverage by the EU negotiating team in exchange for concessions by the UK. Any third country equivalence regime that is substantially similar to that under AIFMD and MiFID II would be well received in the City of London and would provide the necessary reassurance for financial services firms operating in the UCITS space.
The Brexit Dividend
Not all regulatory initiatives by the EU authorities are unwelcome. Indeed, there are many aspects of EU financial services regulation that have been shaped by pre-existing UK legislation (for example, the definition of MiFID investment services and the UK’s market abuse regime). However, certain developments have been less welcome. There is certainly a demand for a “Brexit dividend” at least in the following areas: bankers’ bonus caps, capital requirements regulations, and fund management and marketing rules under AIFMD.
It is open to the UK to operate a twin-track regulatory regime with one track addressing EU business and the other non-EU business. The EU track would comply fully with requirements and the non-EU track would be entirely within the discretion of the UK government (and Parliament). That approach would allow as ample a Brexit dividend as possible—at least under the non-EU track.
What Should You Be Doing Now?
There are a number of actions we recommend that firms consider taking in order to prepare for the eventuality of Brexit:
1. Monitor Brexit developments and consult your legal services providers to help you understand these developments as they unfold.
2. Develop a contingency plan for a “hard Brexit” and how to respond to withdrawal of passporting rights and the absence of a third country equivalent mitigant.
3. Consider a review of your existing contracts:
- The jurisdictional scope of your contracts may be limited. The definition of “EEA” may need to be redefined to continue to cover the UK in the event of Brexit.
- Current investment strategies may require updating. In particular, investment strategies that permit investments in the EEA may need to be amended in order for investments in the UK to continue to be permitted.
- There may be force majeure implications. Uncertainty may drive parties to look for an exit from contracts that are no longer profitable or are underperforming. EU law provisions may render contracts incapable of being performed as originally anticipated. Parties looking for flexibility in such circumstances should consider including Brexit in their force majeure provisions.
- Termination rights. Those wishing for the option to withdraw from potentially loss-making contracts should consider drafting termination rights which will apply in the event of a Brexit (i.e., consider drafting and quantifying withdrawal rights in the event of a “material adverse financial event/downturn” in the markets).
4. Lobby the UK government:
- We recommend lobbying the UK government, either directly or through your relevant trade association, to ensure that your voice is heard and that key financial services sector considerations will be on the agenda when a Brexit deal is negotiated.
- In addition to the range of sectoral trade associations, there are various lobby groups in existence, such as TheCityUK, whose aim is to preserve access to the European markets; the European Financial Services Chairmen’s Advisory Committee which is chaired by Shriti Vadera, former Labour business minister, and the Financial Services Negotiation Forum.
For further information on the implications of Brexit, please visit Morgan Lewis’s Brexit Resource Centre.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers: