Following the UK’s decision to leave the EU, asset management firms of all types and sizes will need to conduct a thorough analysis to understand the potential impact of Brexit. To date, this has been something of a difficult task, not least due to uncertainty as to the future relationship between the UK and the EU in respect of the provision of financial services. Brexit will require asset managers to identify and map out the areas of their business that have cross-border connections both in and outside of Europe, and set out in some level of detail the types of arrangements they currently have in place.
ESMA’s Principles on Supervisory Convergence
During the summer of 2017, the European Securities and Markets Authority (ESMA) released a number of opinions relating to supporting supervisory convergence (i.e., where the national authorities of EU member states take steps to ensure a similar approach with regard to supervision) in the context of the UK withdrawing from the EU. In its opinion issued 31 May 20171, ESMA set out a number of principles to which it expects national competent authorities (NCAs) will adhere when reviewing applications from financial services firms located in the UK seeking relocation of an entity, activity or function to an EU jurisdiction outside the UK. These principles include:
There should be no automatic recognition of existing authorisations.
Authorisations granted by the 27 European NCAs (EU 27) should be rigorous and efficient.
NCAs should be able to verify the objective reasons for relocation.
Special attention should be given to avoid “letter box” entities in the EU27. For example, NCAs should reject any relocation request creating letter box entities where, for instance, extensive use of outsourcing and delegation is foreseen with the intention of benefitting from an EU passport, while essentially performing all substantial activities or functions outside the EU27.
Outsourcing and delegation to third countries should be possible only under strict conditions.
NCAs must be in a position to effectively supervise and enforce EU law.
It is clear that ESMA fully intends to ensure that there is no “fast route” or “accelerated process” to recognise entities currently operating in the UK that wish to set up their business in an EU jurisdiction post-Brexit. Consequently, the decision to establish a new entity in an EU jurisdiction will need to be well thought out, requiring a certain level of commitment. It is inevitable in these circumstances that such an application to obtain authorisation to conduct regulated services would need to comply with the usual administrative process, and be subject to the customary timeframes – this often entails at least six months of planning and up to six months to one year from establishment in the EU (depending on the jurisdiction). Consequently, firms will need to think carefully about whether this is a route they wish to take, and whether it is completely necessary in order to access their desired target clients.
If a firm decides this is a route worth pursuing, it will have multiple options to operate in the EU, ranging from the “lighter-touch” arrangement of acting as a tied agent2 under the responsibility of an EU MiFID-authorised firm, to applying for full-blown authorisation. There have been many discussions by the industry and regulators on the required “substance” for such entities (for example, how many people need to be located in a jurisdiction and the type of functions and/or level of seniority of those individuals), and no doubt this debate will continue for a while.
The Use of Delegation
On 13 July 2017, ESMA issued three further sector-specific principles on relocation from the UK in respect of investment management, investment firms and secondary markets3. Much of the detail set out in these opinions was intended to prevent the possibility of regulatory arbitrage among the EU27. However, it is also clear that ESMA is trying to draw a line in the sand with regard to its expectations of firms wishing to provide services within the EU, either via establishment or on a cross-border basis.
For many, one key aspect that will need to be looked at closely over the coming months is ESMA’s views on the use of delegation of portfolio management and/or other regulated activities from UK entities to EU entities, as well as the interpretation and guidelines that will be set out by each NCA in respect of the use of delegation in its jurisdiction. The use of delegation, particularly in relation to the provision of investment services or portfolio management, is a key element of many structures used by the asset management sector. The use of delegation was relied upon frequently by EU asset managers prior to the decision by the UK to withdraw from the EU. Consequently, any potential change in ESMA’s interpretation or approach to delegation will affect not just future arrangements with UK entities, but also existing delegation arrangements that may be in place between EU entities and entities established elsewhere.
As background, it is useful to look at past guidance provided by ESMA in relation to delegation arrangements, including under the Alternative Investment Fund Managers Directive (AIFMD) and the Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive. The launch of the AIFMD sparked debate regarding the notion of “letter box” entities, with ESMA making it clear that such arrangements were not welcome. The recent opinions by ESMA reiterate this view, and highlight that any delegation arrangement under the UCITS Directive must also follow the principles set out under the AIFMD, to ensure at least the same level of protection is afforded to UCITS investors as to those investing in alternative investment funds (AIFs).
Taking a deeper look at delegation, ESMA set out its expectations that NCAs should be satisfied that there are objective reasons for delegation – and, in this regard, that NCAs should assess the detailed descriptions, explanations and evidence of the objective reasons provided by entities as to the use of a delegation structure. Consequently, NCAs will need to undertake a case-by-case analysis, taking into account the materiality of the delegated activity. In addition, ESMA indicates that where authorised entities delegate portfolio management or risk management activities to non-EU entities, NCAs will need to be satisfied that: (i) the entities selected to conduct the delegated activities are subject to regulatory requirements on remuneration that are equally as effective as those under applicable ESMA guidelines; or (ii) appropriate contractual arrangements are put in place to ensure there is no circumvention of the remuneration rules set out in such guidelines. A secondary, but still important, factor is the need for firms to continue to monitor discussions regarding the EU’s approach to delegation, as any potential change in interpretation or approach to delegation by ESMA or the NCAs could have the potential unintended consequence of impacting existing delegation arrangements between EU entities and non-EU entities (for example, delegation of portfolio management by an Irish or Luxembourg UCITS to a U.S. or Asia-based investment manager).
There is clearly a lot more detail to come as time progresses, particularly approaching March 2019. Concepts such as “transitional arrangements” have been discussed as potential future possibilities, but for now, it is unclear whether a “transitional period” may be put in place or what form such an arrangement might take. In addition, ESMA’s work programme for 2018 is likely to produce more consultation papers or opinions in relation to how NCAs should approach Brexit. It is inevitable that further thought will need to be given as to how the term “equivalence” should be construed and applied across relevant regulations – this may prove complex, given that the concept of equivalence is not used in all EU directives. In addition, in recent weeks, a new term of “regulatory alignment” has come into focus.
Those working in the EU financial services sector know that terms such as equivalence and regulatory alignment may mean different things to different people. Hence, firms will need to wait and see as the politicians and regulators make their intentions clear as to what such terms will mean in the context of Brexit. With this in mind, the only certainty is that there is no set path as to which arrangements may or may not be put in place before Brexit. Consequently, the next few months will be crucial for firms to think about their Brexit planning processes and how best to be able to adapt in a timely fashion as politicians and regulators alike set out their views on how Brexit will be implemented.