Recent EU financial services legislation increasingly seeks to have extra-territorial effect, or at least to influence the global financial markets by dictating the conditions for access to the EU market. This issue has been brought into sharp focus by the different approaches taken by the Alternative Investment Fund Managers Directive (AIFMD) and the proposed amendments to the Markets in Financial Instruments Directive (MiFID II), as well as by the imposition of some obligations on non-EU firms trading in derivatives under EMIR and the requirement for EU registration of credit rating agencies and clearing houses.
Both the AIFMD and MiFID II try to create a more harmonised pan-EU framework governing access by non- EU firms (described in EU legislation as “third country” firms) to the EU market – at least in relation to “professional” investors. However, they take significantly different approaches. The result is that the specific rules that will apply will often depend on applying EU regulatory classifications to the precise activities the non-EU firm undertakes and who it deals with. It also, indirectly, depends on political compromises made at the time of the relevant legislation over how far individual Member States are allowed to retain discretion over the rules applying in their own territories. This is important because historically some Member States, such as the UK, have been very open to global financial services firms and markets, while others, such as France, Spain or Italy, have not. The same legislation may therefore be both liberalising for some EU jurisdictions and restrictive for others.
EU Member States have insisted on retaining control over non-EU firms’ access to their “retail” financial customers so that the new measures principally affect those dealing with, or marketing to, professional investors.
Overall, the impact of the AIFMD and MiFID II is to:
- Limit Member State discretion and enhance the role of both the European Commission (the “Commission”) and the European Securities and Markets Authority (“ESMA”) in determining whether non-EU firms can access the EU market
- Incorporate concepts such as “regulatory equivalence”, “mutual recognition” and “cooperation” between regulators
- Impose new barriers to entry on non-EU firms, which in some cases will be very difficult to negotiate
The AIFMD is already in force, although not all of its provisions relating to non-EU firms have been implemented as yet. Political agreement has been reached on MiFID II but it has not yet been formally approved at the EU level. It is likely to be implemented in 2016/2017.
Similar but different!
One of the aims of the EU has been to create a single internal market. In the financial services sector this generally involves authorisation in one EU Member State being sufficient to allow business to be done in any other EU Member State under a "passport". To date this passport has only been available to businesses incorporated in the EU. For those from non-EU countries, the EU remains a patchwork of different jurisdictions with different regulatory requirements. Both the AIFMD and MiFID II start to move towards a situation where non-EU firms may in future, at least when dealing with professional investors, start to think of Europe (or at least the EU) more as a single block in legal terms, as they have long done in business terms. However, the two sets of rules do so in different ways and are both very limited.
Broadly, the third country provisions in the AIFMD are subject to a three stage process which ultimately aims at making all non-EU firms which manage or market alternative investment funds (AIFs) in the EU (AIFMs) subject to full scale EU authorisation by an EU Member State regulator and full scale compliance with the AIFMD. Once authorised, the non-EU AIFM would be entitled to a passport to market its AIFs to professional investors (not retail) throughout the EU. Under the proposed final regime, a non-EU AIFM will only be able to disapply the detailed AIFMD requirements to the very limited extent that it is “impossible” to comply with both the relevant AIFMD requirement and a mandatory local rule to which the firm is subject and also demonstrate that it compiles with an "equivalent" local rule which has the same regulatory purpose and gives the same level of protection to investors.
The three stages
Stage 1: From 22 July 2013 non-EU AIFMs can, as before, only access the EU market on the basis of EU Member State national regimes, and only to the extent access is permitted at all in the relevant Member State. The AIFMD just adds some EU wide additional requirements which must also be satisfied including:
- Compliance with the AIFMD rules on investor and regulator disclosure and reporting, “asset stripping”, and reporting obligations in relation to EU portfolio companies, for AIFs marketed in the EU
- Supervisory cooperation arrangements between the relevant EU and non-EU regulators
- The non-EU country where the non-EU AIF (and, where relevant, the non-EU country AIFM) is established must not be blacklisted by the Financial Action Task Force (FATF) on anti-money laundering and terrorist financing
In practice these AIFMD requirements, coupled with different implementation timing and interpretation in different EU Member States, have made marketing funds in the EU significantly more difficult than before. Even those countries which previously had a national private placement regime have amended it so that some form of regulatory notification or approval is required before any active marketing is undertaken, while other countries have maintained or increased restrictions on fund marketing for non-EU AIFs and non-EU AIFMs.
Stage 2: It is proposed that some time after July 2015 the option will be introduced for non-EU AIFMs to apply for EU authorisation. During the period from the introduction of this authorisation and passporting regime for non-EU AIFs and non-EU AIFMs in 2015 (or later) to removal of the national private placement regimes in 2018 (or later), non-EU AIFMs will be able to choose between: (a) subjecting themselves to the AIFMD requirements in full in order to have the benefit of a passport to manage EU funds and to market funds to professional investors across the whole EU; and (b) continued use of national private placement regimes on the basis of the requirements outlined in stage 1.
Stage 3: Finally, at least three years after the introduction of an authorisation and passporting regime for non-EU AIFs and AIFMs, it is proposed that national regimes should be removed altogether. Thereafter, non- EU AIFMs will only be able to market actively to EU professional investors, or manage EU funds, if they are EU authorised and fully compliant with the AIFMD.
Phasing in of the passport (under stage 2) and removal of national regimes (under stage 3) is not automatic. First, there is to be an assessment and advice by ESMA and then a decision by the Commission which would produce the implementing legislation to effect the change, subject to powers of the European Parliament and Council of Ministers to object.
Once the passport for marketing and managing by non-EU AIFMs becomes available, the non-EU AIFM will need to identify its EU “Member State of reference1” in order to obtain authorisation in that country before passporting out to other EU Member States. Regrettably, the process for determining the Member State of reference is complex and uncertain and involves multiple opportunities for ESMA, and other EU Member States in which a fund may be marketed or managed, to challenge the determination. Even after the original determination a change may be required if there is a change to the marketing strategy in the first two years after authorisation.
Broadly, authorisation will only be granted if:
- The non-EU AIFM complies with all the normal requirements for authorisation as an AIFM (e.g. controllers, capital, staff and resources, systems and controls, conduct of business, segregation of risk management and valuation from portfolio management, compliance procedures etc.) and the funds it will market or manage in the EU also comply (depositary etc.)
- It appoints a “legal representative" in the Member State of reference which is appropriately resourced, shares compliance responsibility and acts as a contact point
- Supervisory co-operation agreements are in place between the relevant regulators
- The relevant non-EU country is not blacklisted by FATF and has signed an agreement with the Member State of reference which complies with the standards in Article 26 of the OECD Model Tax Convention to ensure an effective exchange of information in tax matters
In addition, the relevant EU regulator must not be prevented by any non-EU laws, regulations or administrative provisions governing the non-EU AIFM, nor by limitations in the powers of the non-EU regulator, from exercising its powers under the AIFMD.
Once authorised, the non-EU AIFM will be required to comply with the full requirements in the AIFMD, save to the very limited extent outlined above where it is subject to local law requirements which are totally incompatible with AIFMD requirements, but protect investors equally well.
By contrast, the general approach under MiFID II governing access for non-EU firms conducting MiFID business2 (“investment firms”) with professional investors on a cross border basis (i.e. without establishing a branch in the EU) applies concepts such as “equivalence” and “reciprocity” and provides for registration with ESMA rather than authorisation by individual Member State regulators.
Whilst the conditions are tough, it is arguably preferable to the approach taken by the AIFMD, which proposes the introduction of a full scale EU authorisation and compliance regime for non-EU AIFMs (which will be mandatory from stage 3 onwards). However, MiFID II confines access under the ESMA registration regime to dealings with authorised firms and large institutions which qualify as “eligible counterparties” ("ECP") or "per se professional clients" (“per se PC”), rather than, as the AIFMD does, including also those individuals, smaller undertakings and local authorities which may in some circumstances elect, or opt up, to be treated as “professional investors”.
The conditions for ESMA registration are:
- The Commission adopts an equivalence decision confirming that the legal and supervisory framework of the relevant non-EU country is equivalent in effect to the requirements applicable to EU investment firms and provides EU investment firms with equivalent access to its markets (the reciprocity test)
Broadly, the equivalence test requires “equivalency in effect” rather than strict equivalence with the detailed EU regulatory requirements. Nevertheless, it may still have the effect of preventing investment firms from a number of non-EU countries from accessing the EU market. Much will depend on how the Commission interprets these requirements in practice.
In order to be considered equivalent, a non-EU country must also provide an “effective equivalent” system for reciprocal recognition of investment firms authorised under MiFID. A ‘reciprocity test’ has been introduced in other EU financial services legislation and it is arguably preferable to the approach taken by the AIFMD:
- The non-EU investment firm is authorised in the jurisdiction where its head office is established and is subject to effective supervision and enforcement, ensuring compliance with the requirements applicable in that country
- Supervisory cooperation arrangements are in place between ESMA and the relevant non-EU regulator
Interestingly, the absence of a positive equivalence decision by the Commission is not necessarily fatal to the chances of the non-EU investment firm accessing any part of the EU market. MiFID II allows national regimes to continue in parallel so that non-EU investment firms will still also be permitted to carry on MiFID business with investors and clients in individual Member States on the basis of those Member States’ own access rules, provided that those access provisions do not place non-EU investment firms in a more favourable position than EU firms. Broadly, subject to a number of conditions, the UK's overseas persons exclusion allows certain firms to conduct certain types of regulated business with some sophisticated UK investors and clients without triggering the requirement to be authorised in the UK. This exclusion is available to both EU and non-EU investment firms, so it would appear that it will survive the implementation of MiFID II, albeit in modified form.
As an alternative to ESMA registration, if a non-EU investment firm wishes to establish a physical presence in the EU it will be permitted to conduct MiFID business through an EU branch. However, this will require the non-EU investment firm to be authorised by the relevant EU Member State regulator where the branch is established and fully comply with the various conduct, governance and systems and controls obligation in MiFID II. This obligation is closer to the requirements on non-EU AIFMs in stage 3 except that there is no provision for selecting a "Member State of reference" and instead the firm must apply for authorisation wherever it wishes to establish a branch.
The requirements for branch authorisation are that:
- The non-EU firm is authorised and subject to effective supervision and enforcement in its home state for the relevant business (EU Member State regulators must have due regard to the FATF recommendations with respect to the non-EU country)
- The non-EU firm has joined an EU recognised investor compensation scheme
- The branch has sufficient initial capital
- The persons serving on the management board of the non-EU firm comply with MiFID governance requirements
- Supervisory cooperation arrangements are in place between the relevant EU Member State regulator and the non-EU regulator
- The relevant non-EU country has signed an OECD compliant tax information exchange agreement with the relevant EU Member State
- The relevant EU Member State regulator is satisfied that the branch will be able to comply with its obligations under MiFID.
An authorised branch of a non-EU investment firm can avail itself of a passport to carry on MiFID business with ECPs and per se PCs on a cross border basis across the EU without the need to establish further branches in the EU provided:
- The Commission has adopted an equivalence decision
- There are supervisory cooperation arrangements in place between ESMA and the non-EU regulator and where relevant between EU home state regulators (i.e. where the passport is being exercised)
The passport cannot be used by the non-EU firm if the equivalence decision is withdrawn. If that happens, non-EU firms will only be able to access that market if the individual Member State permits it. Non-EU firms will, for the first three years immediately following a Commission equivalence decision, have the option to access the EU market through the pan-EU registration regime or under the EU Member States’ respective national regimes. This is a little similar to the Stage 2 period under the AIFMD, which is also intended to last at least three years, a period which the Commission seems to think is an appropriate testing period.
Access to the EU market for non-EU firms who wish to conduct MiFID business with elective professional clients and retail clients will be at the discretion of the relevant EU Member State. However, to the extent that Member States require the non-EU firm to establish a branch then compliance with the conditions summarised above and the various conduct of business, governance and systems and controls obligation in MiFID II will be required. Such branches will not be entitled to the passport.
So it is open to question how far non-EU firms which wish to establish a physical presence in the EU will choose to do so through a branch rather than, as at present, an EU subsidiary which will have full passporting rights. However, the option of ESMA registration for remote dealings with ECPs and per se PCs could well prove attractive.
Own exclusive initiative
Both the AIFMD and MiFID II purport to allow EU clients and investors to access the products and services of non-EU firms when they do so on their own initiative rather than as a result of the firm's marketing efforts. Thus, it will still be possible for non-EU investment firms to carry on MiFID business with EU clients and counterparties without the need for registration with ESMA or authorisation as a branch where the MiFID business is provided at the client’s “own exclusive initiative”.
Similarly, the AIFMD says that it does not affect the ability of a professional investor to invest in AIFs at its own initiative, irrespective of where the AIFM and/or the AIF is established. The precise scope of this test is currently unclear and non-EU firms may well find that in practice it is very difficult to rely upon it, especially when advertising their services through the internet or seeking to extend a relationship beyond the product or service originally requested.