The European Securities and Markets Authority foresees regulatory and arbitrage risks in Brexit and a potential “race to the bottom” as certain national regulators jostle for and grab UK market share. On 31 May 2017, ESMA delivered an Opinion on achieving a common approach to supervision among regulators in EEA member states in the context of Brexit.
Esma concedes in the Opinion that “the UK plays a prominent role in the EU Single Market” and predicates the Opinion on the fact that the relocation of financial firms, activities and functions following the UK’s decision to withdraw from EU creates what it describes as “a unique situation which requires a common effort at EU level to ensure a consistent supervisory approach to safeguard investor protection, the orderly functioning of financial markets and financial stability.”
UK based financial market participants planning for a worse case “hard” Brexit scenario whereby UK becomes a “third country” and UK participants lose their passporting rights, are giving serious consideration to setting up an affiliate in one of the EU27 countries in order to retain passporting rights through and beyond Brexit, but not relocating lock, stock and barrel to EU27. ESMA acknowledges that UK participants will seek to minimise the transfer of the effective performance of those activities to the EU27 by relying on the outsourcing or delegation of certain activities to UK participants.
On 13 July, ESMA issued a further three opinions focusing on regulatory risks in collective investment management (i.e. Ucits and AIFS), Mifid investment firms and trading venues, respectively, putting flesh on the bones of the May Opinion.
All four Opinions assume a “hard” Brexit and no special bespoke deal with UK on Single Market access.
The May Opinion enumerates nine principles, broadly:
- no automatic recognition of existing authorisations of UK firms post-Brexit;
- authorisations granted by EU27 regulators should be rigorous and efficient;
- EU27 regulators should be able to verify the objective reasons for relocation and only confer authorisation if satisfied it is not motivated by regulatory arbitrage. Regulators should particularly scrutinise applications where it appears that an entity intends to pursue the greater part of its activities in other member states;
- avoid letter-box entities. This principle is aimed squarely at the possibility UK firms will relocate in the EU27 to retain passporting rights but delegate back to the UK substantial activity leaving the firm in the EU27 a mere “letter-box”;
- strict conditions for outsourcing and delegation to third country firms;
- substance requirements to be met. Certain key activities and functions should be undertaken in the EU27, including at least the substance of decision taking. In certain sector specific circumstances, important activities and functions, including internal control functions, IT control infrastructure, risk assessment, compliance functions and key management functions cannot be outsourced and delegated;
- sound governance. Key executives and senior managers of EU27 authorised firms should be employed in the member state of establishment and work there albeit not necessarily full-time;
- Esma expects regulators should be able to conduct on-site inspections of outsourced or delegated activities without any prior third party authorisation; and
- there should be co-ordination among regulators to ensure effective monitoring by Esma which includes initiating investigations of possible breaches of EU law.
Although these principles are expressed in general terms, in some respects, they seem to impose requirements beyond those in the underlying Directives. Much will depend upon how the principles are interpreted and applied by individual regulators.
Some common themes emerge from the July Opinions on investment management and investment firms, as follows:
- EU27 regulators may not fast-track any applicants. This is aimed at inhibiting member states from grabbing UK market share and the concomitant risks posed by any “race to the bottom”;
- regulatory arbitrage is to be discouraged;
- UK firms setting up in the EU 27 should establish a meaningful presence with sound governance based there;
- firms seeking to set up in the EU 27 and then open a non-EU (eg, UK) branch must be able to justify their plans by reference to the services to be provided from the branch and demonstrate sound local governance of the branch;
- board members and senior managers should be experienced and able to carry out independent decision-making and not hold too many directorships thereby becoming over-committed; and
- delegation structures must be based on objective reasons in order to, say, optimise business functions and processes, save costs, benefit from additional expertise in specific markets or provide access to global trading capabilities.
Ominously, Esma warns that post Brexit any (a) delegation of investment management to the UK will only be permitted if in compliance with AIFMD or Ucits and (b) any outsourcing of portfolio management to the UK must comply with Mifid II and cooperation agreements between EU27 and UK regulators should be in place.
UK firms seeking to establish a presence in the EU27 from which to operate will need to give detailed consideration and focus to the resources and operational substance which will need to be located in the jurisdiction in which that presence is established.
Simon Currie and William Yonge are Private Investment Funds partners at Morgan Lewis