On 13 July 2017, the European Securities and Markets Authority (ESMA) published three opinions, setting out sector-specific principles in the areas of investment firms, investment management and secondary markets. These follow from on the cross-sectoral opinion that ESMA published on 31 May 2017, with the intention of achieving supervisory convergence across the EU27 jurisdictions in the wake of the UK’s decision to withdraw from the EU (Brexit). The cross-sectoral opinion was addressed to the national competent authorities (NCAs) of the EU27 and sets out nine general principles that they should apply with respect to UK financial institutions seeking to relocate to their jurisdictions.

What are the nine general principles?

  • No automatic recognition of existing authorisations.
  • Authorisations granted by EU27 NCAs should be rigorous and efficient.
  • NCAs should be able to verify the objective reasons for relocation.
  • Special attention should be granted to avoid letter-box entities in the EU27.
  • Outsourcing and delegation to third countries is only possible under strict conditions.
  • NCAs should ensure that substance requirements are met.
  • NCAs should ensure sound governance of EU entities.
  • NCAs must be in a position to effectively supervise and enforce Union law.
  • Coordination to ensure effective monitoring by ESMA.

Overview of the opinion

This article considers the ESMA opinion relating to investment management, which is also addressed to NCAs and sets out principles relating to AIFMs and UCITS management companies (referred to as authorised entities). These principles ‘add flesh to the bone’ of the cross-sectoral opinion and cover authorisation, governance and internal controls, delegation and effective supervision.

Some of the key points set out in the opinion include the following:

ESMA stresses the importance of NCAs paying attention to conflicts of interest that may arise when authorised entities are set up/relocated in EU27 jurisdictions. These may arise through the group structures which authorised entities form part of (for example board members/senior management may hold positions at service providers to/funds managed by that authorised entity). NCAs should assess these conflicts (paragraph 21).

  • When making that assessment, NCAs should scrutinise board members with a high number of directorships (whether executive or non-executive), to consider whether they can meet their obligations. NCAs should also consider issuing guidance on appropriate thresholds (in terms of aggregate time commitment) for directorships (paragraph 23).
  • The organisational set-up of the authorised entities should be such that NCAs can carry out on-site visits of their premises at any time, without prior notice, and can meet senior management on a day’s notice (para 28).
  • In terms of determining whether the delegation rules set out in the EU investment management legislation are complied with, NCAs should give special consideration to the appointment of investment advisers. An arrangement whereby an authorised entity receives investment advice, but does not carry out its own qualified analysis before making the investment decision, would be deemed to be a delegation of portfolio management. ESMA further notes in the context of the prohibition on all portfolio management activities being delegated that if an authorised entity were to merely consider whether an investment complies with investment restrictions, this would not constitute portfolio management (i.e. the AIFM/UCITS Manco must do more than this) (para 40).
  • When seeking to delegate, authorised entities should provide evidence to NCAs that the delegation is justified for objective reasons: to optimise business functions and processes, save costs, and benefit from additional expertise (para 44). In terms of the cost-saving criterion, authorised entities should provide evidence that the financial benefits of the envisaged delegation structure outweigh the estimated costs of performing the delegation function internally, taking into account the due diligence and monitoring costs associated with the delegation (para 45).
  • ESMA indicates that authorised entities in the EU27 should have at least 3 locally-based FTE staff dedicated to portfolio and/or risk management and/or the monitoring of delegates. Where this is not the case, NCAs should apply additional scrutiny (para 60).

Practical comment

Whilst the opinion does not (and cannot) change any of the law regarding fund management, it is clearly a warning shot to those regulators who were minded to be flexible in terms of allowing UK based fund managers to make use of European structures for continued market access within the EU after Brexit. It is also evidence of the lack of influence which the UK, the Member State where many fund sponsors in the alternative asset space are located and which has traditionally had a strong influence in many of these discussions, now has in ESMA’s decision-making process.

On the face of it, the purpose of ESMA’s opinion is to maintain the EU’s harmonised approach to regulating investment management by preventing NCAs from making concessions to lure financial institutions to their territory in order to gain a competitive advantage. This is consistent with the approach set out in the cross-sectoral opinion.

However, ESMA’s recommended approach on enforcing delegation provisions represents potential obstacles for fund managers currently based in the UK. For example, with regards to firms under the remit of the AIFMD, it had been expected that many UK financial institutions would set up an AIFM (or use a service provider to provide this function) in an EU27 jurisdiction, such as Luxembourg, Ireland or Malta, with a London-based investment adviser appointed to provide investment recommendations to the AIFM. Following ESMA’s opinion, this approach can still be followed, but the structure will need to be designed in a more rigorous way to ensure sufficient substance in the EU27 jurisdiction.

Unfortunately, it is not clear what exactly will be required in order to evidence that ‘qualified analysis’ is being undertaken by the AIFM. Paragraph 40 states that authorised entities must keep clear record-keeping and documentation of the qualified analysis they carry out following the receipt of investment advice but it offers no detail as to what exactly constitutes qualified analysis. What is clear is that this will entail a shift in the balance of decision-making in investment manager-investment adviser arrangements, with the former having to play a greater role in the investment decision.

One implication may be that UK financial institutions will have to relocate some of their investment professionals so that they can demonstrate that investment decisions are being made ‘on the ground’ in the relevant EU27 Member State. Interestingly, although one of the notes in the opinion is that additional scrutiny will be placed on those using the services of supermancos/third party AIFMs, it seems likely that all of the additional substance/governance requirements will be more easily met by such organisations (who will have to step up to the plate if they are going to maintain their business models), than by firms seeking to establish their own presence in the relevant jurisdiction, unless they have sufficient resources to set up something with sufficient local substance. It may also result in a consolidation of the supermanco, industry which has in recent years seen the establishment of numerous firms offering this service.

This is likely to be one of the central issues when it comes to Brexit negotiations on financial services, given the potential adverse effect which changes to these rules and their interpretation may have not only on the UK but on European and global markets (as recognised by Megan Butler, Director of Supervision at the FCA).