Investment firms currently face two key challenges: the first, planning for MiFID II and the second, planning the best way forward post Brexit.
What is the best way forward will vary because a diverse range of firms are caught within MiFID's scope (and prospectively within the wider scope of MiFID II); a MiFID firm is often part of a wider, international financial services business; and the nature of a firm's client base will influence the decision.
We set out below though some preliminary thoughts on some key topics to consider in relation to the post Brexit scenarios.
Post the "leave" vote on 23 June, UK asset managers, along with all other financial institutions and businesses in the UK, are now having to address the potential consequences for their businesses, and their products and services:
- At first glance there might be an attraction to Brexit, because the UK could apply a regulatory brake to the never ending deluge of regulation from the EU Commission.
- On the other hand there seems to be much to lose, particularly if we cannot participate in the Single Market place, and with the potential for further UK business operations or product to move to other EU jurisdictions.
Business as usual, initially
The FCA's statement on the European Union referendum issued on 24 June indicates what one might expect: in the short term, on a day to day basis, it should be business as usual:
"Much financial regulation currently applicable in the UK derives from EU legislation. This regulation will remain applicable until any changes are made, which will be a matter for Government and Parliament.
Firms must continue to abide by their obligations under UK law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect.
Consumers' rights and protections, including any derived from EU legislation, are unaffected by the result of the referendum and will remain unchanged unless and until the Government changes the applicable legislation."
For MiFID firms, the main immediate challenge is planning for implementation of MiFID II in order to have the chance to meet the January 2018 implementation date. (See our MiFID II update providing our Level 2 and Level 3 text tracker. Our Level 1 text publication is also available on request.) The UK position for implementing MiFID II is now becoming clearer:- we now have the FCA's second Consultation Paper (CP 16/19) and the third one on conduct of business and product governance issues is expected soon.
However, this expectation of continuing to implement European legislation and carry on with business as normal will in all likelihood remain only a short term approach, pending developments on some of the considerations raised below.
Potential loss of the MiFID passport
Thinking ahead to how negotiations for Brexit might progress, the main focus for MiFID firms is of course on the issue of potential loss of the MiFID passport (and for those MiFID firms which have a wider range of business, possibly some product passports too).
Clearly there is interest in maintaining participation in the Single Market from most in the asset management sector – certainly those with established businesses utilising a MiFID passport (and possibly additional passports if, for example, in the UCITS space). However, whatever the wishes and needs of the asset management industry, if (as at present seems likely) the corollary of having access to the Single Market will be having to agree to continuation of the right for free movement of EU citizens, continued participation in a Single Market might not be an achievable outcome within the Brexit negotiations.
MiFID firms benefit from MiFID I and, prospectively, MiFID II passports. MiFID I already enables a wide range of businesses to passport on a branch or services basis throughout the EU for investment management and advisory services, and the scope of MiFID is to be widened with effect from 3 January 2018.
If and when the UK becomes a "third country", UK firms would have limited options. There are three main options:
keep outside the scope of MiFID
Assuming services currently come within the scope of MiFID, there is little scope for new ideas here.
Under Article 42 of MiFID there is a general exemption, which is applicable across the EU, allowing for provision of services at the exclusive initiative of the client in an EU Member State. However, whilst relying on arrangements like this may allow some degree of activity to be undertaken from the UK into Europe, this is not likely to provide a sound basis for operating a business.
establish a branch, utilising Article 39 of MiFID II
Article 39 of MiFID II allows each individual Member State to opt into a regime under which the Member State may require a third country firm that intends to provide
investment services, or perform investment activities (with or without any ancillary services) to retail clients or to professional clients, to establish a branch in that Member State which would be authorised by the relevant regulator in that Member State.
This route would be available only where the conditions in Article 39 are fulfilled regarding:
- AML status,
- co-operation arrangements being in place between competent authorities,
- sufficient initial capital being at free disposal of the branch,
- one or more persons being appointed to be responsible for management of the branch,
- the third country having signed an agreement with a Member State where the branch is to be established which complies with the standards laid down in Article 26 of the OECD Model Tax Convention on income and on capital and ensures an effective exchange of information on tax matters; and
- the firm belonging to an investor compensation scheme authorised or recognised in accordance with Directive 97/9/EC.
The branch of the third country firm would be obliged to comply with the provisions to which Article 41(2) refers, which would apply various provisions of MiFID II and MIFIR such as organisational requirements, conflicts of interest and various investor protection measures. A Member State though would not be able to impose any additional requirements on the organisation and operation of the branch in respect of matters covered by MiFID. It would also be obliged not to treat any branch of third country firms more favourably than EU firms.
This option involves the extra cost of running a branch but allows the head office of the branch still to be run from the UK. It does not however provide any passporting rights from the selected Member State into other Member States. Also, in order to follow the Chapter IV provisions, it will be necessary for the other EU Member States to decide to opt in to the Article 39 MiFID II regime and then for the various conditions to be met, so it would not be an automatic route.
establish a branch in a Member State utilising Article 46 of MiFIR
The second practicable option to consider would be to explore utilising Article 46 MiFIR and other provisions of Title VIII within MiFIR.
These would apply if the Commission makes an equivalence decision in respect of the UK. In theory, the UK could easily meet the equivalence requirements, but it is possible that this decision could be politicised and slow in coming.
If the UK is deemed to meet the equivalence requirements, UK firms could seek registration with ESMA. If a UK firm has established a branch under MiFID II Article 39, they might also benefit from a limited passport. A third country firm can provide investment services or perform investment activities with or without any ancillary services to eligible counterparties and to per se professional clients (but not opt up professional clients) without the establishment of a branch, where it is registered in the register of third country firms kept by ESMA in accordance with Article 47.
Article 47 provides for the Commission to adopt a decision in relation to a third country stating that the legal and supervisory arrangements of that third country ensure that firms authorised in that third country comply with legally binding prudential and business conduct requirements which have equivalent effect to the requirements set out in MiFID II and MiFIR, the CRD IV Directive, and implementing measures adopted under those measures, and that the legal framework of that third country provides for an effective equivalent system for the recognition of investment firms authorised under third country legal regimes. ESMA is to establish co-operation arrangements with the relevant competent authorities whose legal and supervisory frameworks have been recognised as effectively equivalent in accordance with this provision.
If eligible, ESMA shall register a third country firm that has applied for a provision of investment services or performance activities throughout the union in accordance with Article 46(1) where the following conditions are met:
- the Commission has adopted a decision in accordance with Article 47(1);
- the firm is authorised in the jurisdiction where its head office is established to provide the investment services or activities to be provided in the EU and it is subject to effective supervision and enforcement ensuring full compliance with the requirements applicable in that third country; and
- co-operation arrangements have been established pursuant to Article 47(2).
Where a third country firm is registered in accordance with Article 46 MiFIR, Member States would not be able to impose any additional requirements on the third country firm in respect of matters covered by MiFIR or by MiFID II and will not be able to treat third country firms more favourably than EU firms.
Where a third country firm established in a country whose legal and supervisory framework had been recognised to be effectively equivalent, and would be authorised in accordance with Article 39 of MiFID II, it would then be able to provide the services and activities covered by the authorisation
to eligible counterparties and per se professional clients in other Member States of the EU without the establishment of new branches.
It would however need to comply with the information requirements for cross border provision of services and activities in Article 34 of MiFID II. Note that the branch would remain subject to the supervision of the Member State in which a branch was established in accordance with Article 39 of MiFID – although the relevant regulators of the Member State where the branch is established and the regulators of the host Member State could establish proportionate co-operation agreements in order to ensure that the branch of the third country firm providing investment services within the EU delivers an appropriate level of investor protection.
Establishing therefore whether the Commission will make an equivalence decision under Article 47 of MiFIR will be an important item for the exit negotiations: one cannot assume that the Chapter IV MiFID II regime will be utilised by all Member States. The idea of utilising Article 42, so that there would be a business built on providing services only at the exclusive initiative of the client, would be unrealistic.
These options are currently being debated – and of course for a UK based MiFID firm are likely preferable to the alternative of establishing a new MiFID scope firm in an EU Member State. This final alternative would involve establishing a separate subsidiary or sister firm in a Member State that obtains full authorisation in that Member State and runs EU-facing activities through that new firm. For UK based investment services businesses, this would involve extra cost and duplication of activities but the new subsidiary would enjoy full passporting rights across the EU. The main concern of course with this final alternative is the possible need to relocate portfolio managers and core investment management type activities. Hence the focus on the options explained above.
Restructuring of groups
How firms may respond to the Brexit challenge will depend on their own particular circumstances.
Many fund managers have only recently completed the restructuring of all of their non-UCITS fund business with the implementation of AIFMD, and UK fund managers may now be faced with the prospect of restructuring their groups in order to maintain their business activities in Europe, and potentially wider, and indeed utilise Luxembourg and Dublin based funds for the majority of markets.
The consequences of Brexit for investment managers may be seen as simply an inconvenient evolvement of the position for major firms: many have already long established operations in other EU Member States. For many investment managers, the likely result will be to focus even more of their business in non-UK firms within their groups, in particular those established in other EU Member States.
Brexit will however pose more of a challenge for smaller firms and new entrants into the market place – and certainly new entrants will be discouraged from considering having their main establishment in the UK. It may well be that for those with European focused businesses they will be encouraged to set up their MiFID firms in other EU Member States quite promptly.
Some international firms may take a view on the business they do within Europe and decide to establish themselves outside of the EU, particularly if their client base is itself, in the main, outside of the EU. Whether the third country will end up being the UK or a third country outside of the EU, there could then be a debate about the Article 39 MiFID II or Article 46 MiFIR branch options explained above.
For each firm, careful consideration of all the relevant circumstances is needed to assess the most appropriate option for their business.
Self-determination of UK regulation?
One considerable advantage of Brexit is the expectation that the UK could be free from EU regulation – with the UK determining its own regulation going forwards. UK regulators could resist some of the initiatives in the European Commission with which both regulators and the industry might disagree.
There are however good reasons for doubting this perceived advantage of Brexit. There are a few inhibitors to the UK determining its own regulation going forwards.
Known for providing a prudent regulatory environment with close attention to investor protection concerns, the UK's general approach is unlikely to change. Indeed, we should not be expected to change given that UK regulators will still be expecting to take a lead within the wider global regulatory environment – the IOSCO framework etc. And the Government and the PRA and FCA will be expecting to pursue their independent and progressive approach in any new post-Brexit environment. Certainly, we might expect the UK regulators to follow through on their own specific initiatives such as the senior managers regime and the outcome from the Fair and Effective Markets Review, RDR, regulatory sandbox, embracing innovation, etc.
Many of the initiatives now coming through from the EU are in fact in areas where the UK was the first to establish the relevant regulation, and indeed where the UK in some instances still maintains gold plating. It would be unrealistic to expect
initiatives regarding costs and charges transparency, transaction reporting, inducements or provisions on investment research not to continue to be pursued. It would also be unrealistic to look for a lighter regulation of authorised investment funds. Given that many EU Directives, for example, the UCITS regime, have had strong support from the UK the UK is highly likely to choose to continue much existing EU-driven existing regulation. We see little, if no, prospect of a lighter regulatory burden for UK authorised firms.
No doubt there might be some examples where there might be an improvement. Whilst most of the over regulation which you might mention might have been driven by the UK regulators, there are some examples where European regulation has been unwelcome, and the UK might prefer to revert to the old provisions. In the main though, the advantage (were it to be free to do so) would be the UK determining its position rather than having to accept the composite EU view.
Depending on the nature of the deal with the EU, it may be that the UK still needs to maintain some equivalence to the EU legislation:
- If the UK were to adopt the Norway model, in order to benefit from the single market, would be subject to the EU Rules although not able to influence them.
- If, as is more to be expected given that a bespoke new solution for the UK seems increasingly likely, the UK may need to maintain a comparable regime in order to benefit from some third country provisions such as those mentioned in respect of investment services above, the UK regulators would need to retain an eye on the EU position in order that this is achieved. Where EU legislation provides for institutions authorised in countries with equivalent levels of legislation to enjoy special access rights, no doubt the UK would look to obtain status as such a country. The UK having an equivalent financial services regulatory regime would be a precondition to benefitting from these although this is not a given, notwithstanding the UK being stricter in several regulated areas or conforming with international regulatory standards that are followed by most major financial centres (including the EU).
Regardless of the position negotiated with the EU, generally freedom for the UK to determine its own position will not necessarily be entirely feasible. The potential for this being practicable would rather depend on there being more of a domestic focus on the UK market place than a global one. Given the globalisation of asset management businesses, this would not seem to us to be practicable.
Consequently it will take some time to see how UK regulation might develop if self standing. As the Chairman of the FCA has expressed it in a speech on 30th June : "the need for "better regulation" and not just "bulkier regulation"."
The legislative position
What happens to existing EU related laws in the UK?
On all fronts, in the short term, simply allowing all UK domestic law derived from the EU to lapse or revoking would be unworkable. It will be a complicated process to work through how to move towards a new UK regime.
EU laws are deeply embedded in the UK. Certainly Regulations which are directly applicable in Members States but would presumably cease to apply on Brexit unless replicated or preserved by new legislation (which might well in any event be the likely outcome, at least as a stop gap until tailored legislation can be put in place). EU Directives are mostly required to be transposed and so implemented in the Member States, and so the UK could reverse its previous primary legislation or sometimes secondary legislation pursuant to the European Communities Act 1972 insofar as it wished to do so.
We think it is highly likely that the UK Government will introduce some form of overarching legislation to address the fundamental legal uncertainties caused by Brexit. An obvious parallel (ironically) is the position at the time the UK was considering adopting the Euro where it seemed likely that legislation would be required to avoid any doubts about the continuity of contracts notwithstanding the change of currency. Quite though how this will be devised will depend on how the Brexit negotiations develop.
Many now seem to think that the likelihood – or perhaps hope? - is that the UK will end up with its own special new regime which does not follow any particular model currently enjoyed by another European country. At this point, it is too early to tell what this might look like.
Process and timing
Given the fact that no Member State has so far left the EU, there is uncertainty regarding the way in which the procedure and the negotiations involved will be progressed. A period of intensive negotiation is likely once the UK's Government position becomes clearer. It is conceivable that the EU will offer further concessions in an attempt to head off Brexit but it is difficult to see how this would be compatible with the Brexit vote and with the nervousness of the EU in discouraging further countries from leaving the EU.
The UK Government is likely to use Article 50 of the Treaty on European Union under which a Member State wishing to leave the EU must give two years' notice of its intention to withdraw, although that period may be extended with the agreement of all 27 remaining Member States. Reaching the end of the two year period without reaching such an agreement, and without all 27 Member States accepting an extension, would result in the UK leaving the EU with no immediate replacement position agreed. The reluctance to give the Article 50 notice prematurely is likely indicative of the concerns.
Uncertainty as to the scope of the Article 50 negotiations is also a point of interest – there is a need for some certainty as to the post Brexit environment rather than simply the details of how the UK might exit. We understand that the EU Commission is deputing two separate teams to work on the Article 50 and the post Brexit UK regime as separate matters. The very fact that the exit process could of itself work on an unsatisfactory basis is a negative issue.
So the timing is tricky. It looks at the moment as though, in theory at least, several major initiatives - most relevant to investment firms, MiFID II and PRIIPs, which are in the process of being implemented by the EU will come into force before the UK can negotiate its exit terms. The impact of these measures and how they might be modified will themselves be items for negotiation.
Dealing with uncertainty
With the well-established EU framework for asset managers and the particular perceived strengths of the EU UCITS and AIF products, the impact of Brexit may be particularly marked for UK based asset managers.
With the current lack of specifics as to how the process will work through and what the end result might be, in reality, the most important issues for the moment still remain the intangible ones – the lack of certainty, and perception problems which the UK will face when out of the EU.
We should hope that there is a speedy negotiation of whatever the basic shape of "out" looks like so that UK based asset managers can decide how best to move forwards.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.