Brexit: letting the dust settle
Published on 29th Jun 2016
Last week Britain voted to leave the European Union. The result stunned commentators and sent shockwaves through financial markets. Given how reliant the UK fund management industry has become on pan-European “passports”, this has raised serious questions about the likely impact of Brexit on the industry.
Our view is that the impact on the fund management industry will be both significantly delayed and more muted than many are predicting. Fund managers should, of course, be alive to the potential implications of ‘Brexit’ but should not make hasty, and potentially expensive, decisions until the dust has settled.
EU law continues to apply
Despite the jitters and the general effect on the markets there will be little immediate day-to-day change for fund managers for some time. EU-derived law continues to apply until the UK leaves the EU. In particular, this means that the passporting rights that allow firms to conduct activities on a cross-border basis will continue to apply throughout that period.
The formal withdrawal process will begin when the Government invokes Article 50 of the European Union treaties. It is currently thought that this will not happen until Autumn 2016 at the earliest. Once invoked, there is a two-year window for the UK to reach a deal with the remaining Member States, although this can be extended by unanimous agreement. Until the withdrawal agreement is approved by the European Parliament, the UK remains an EU Member State and, as such, European Union law and regulation continue to have effect. Given the complexity of the issues at stake, and the fact there is no precedent for the withdrawal of a Member State from the EU, many commentators expect that this two year period will need to be extended.
Throughout that period, existing passporting rights will continue to apply. Funds that are in fund raising mode already (or intend to raise shortly) are unlikely, in the short term at least, to have their fund raising plans affected.
The UK may still have access to passports once it leaves the EU
Leading figures, from London’s mayor Sadiq Khan to the City of London Corporation, have stated that protecting passporting rights will be vital in safeguarding the financial competitiveness of the City. Negotiations on passporting rights will be intertwined with negotiations on whether the UK will be granted access to the single market.
Whilst the Government will push for access to the single market it is not clear which model it will attempt to follow. Countries that currently enjoy such access include Norway, a member of the European Economic Area (EEA), and Switzerland, a member of the European Free Trade Association (EFTA). But prominent ‘Leave’ campaigners have already rejected the Norway and Switzerland models arguing instead for a deal that exempts the UK from free movement of people and single market regulations whilst allowing access to the single market. The EU has said that it will not grant the UK access to the single market unless it accepts the free movement of people as a condition. The extent of the trade-off between access to the single market and accepting free movement of people is likely to be at the heart of the negotiations.
Accordingly, unless the UK joins the EEA or is able to negotiate a bespoke deal ensuring access to the single market, the UK will acquire “third country” status under relevant directives such as the AIFMD, EuVECA, MiFID and UCITS. This will restrict the passporting rights that authorised UK firms currently enjoy under those directives, although there are still opportunities for using passports even if the UK does not continue to benefit from single market access generally.
The Alternative Investment Fund Managers Directive (AIFMD) applies to the EEA, not just the EU. EEA-based alternative investment fund managers (AIFMs) can market their EEA-based alternative investment funds (AIFs) to professional investors throughout the EEA as a result of the pan-European marketing passport. Non-EEA AIFMs (or EEA AIFMs marketing non-EEA AIFs) can market to EEA investors only if they comply with individual Member States’ national private placement regimes (NPPRs) plus additional AIFMD conditions on disclosure. The NPPRs vary by Member State in the regulatory burden they impose on the AIFM (some require regulatory approval and compliance with specific rules such as the appointment of a local depositary; others merely a notification to the regulator).
If the UK left the EU but remained in the EEA, AIFMD would continue to apply, with no impact for UK based AIFMS or AIFs.
Even if the UK leaves the EU and the EEA, AIFMD already provides for the extension of the marketing passport to third countries that are recognised as equivalent regimes. ESMA has delivered initial advice on extending the marketing passport to Guernsey, Jersey and Switzerland. Whilst the precise timing of this remains unclear it is likely that, at some point, a number of non-EEA jurisdictions will benefit from some form of pan-European marketing passport. It is reasonable to expect that the UK would at least be in the list of countries which ESMA would consider for these purposes.
Even if the marketing passport were not extended to the UK, UK-based managers could continue to establish AIFs in other jurisdictions which do benefit from the passport (e.g. Luxembourg, or the Channel Islands if it is extended there) and to provide investment management or advisory services to a local AIFM of those funds under the extended MiFID II passport as discussed below.
It is also worth remembering that the rules in AIFMD and the NPPR restrict marketing in the EEA, so it is not currently expected that the UK’s exit would have any effect on funds which have closed for subscriptions before that period or which are not seeking to raise capital in the EEA or outside the UK.
The Regulation on European venture capital funds (EuVECA) and Regulation on European social entrepreneurship funds (EuSEF) provide a separate pan-European marketing passport for EEA-based AIFMs or EEA-based AIFs, if they satisfy the criteria for classification as a EuVECA or EuSEF. These Regulations were brought about by the desire at European level to keep the market for these kind of funds (which are often too small to have access to the AIFMD passport) open within Europe.
Each of these Regulations contains provision for the Commission to review the possibility of allowing venture capital/social entrepreneurship funds established in third countries to use the designation “EuVECA” or “EuSEF”, and this is one of the subjects of the Commission’s consultation on those regimes which closed for comment in January 2016. The Commission is due to publish a proposal resulting from this consultation in July 2016. This procedure is therefore slightly behind the equivalent under AIFMD, although the issues for UK based managers of EuVECA and EuSEF funds will be similar.
Under the Directive on Undertakings for Collective Investment in Transferable Securities (UCITS), funds satisfying the requirements of the Directive can use the designation “UCITS” and be marketed on a pan-European basis to both professional and retail investors. UK-based UCITSs would most likely lose their designation as UCITS and cease to benefit from this pan-European marketing passport, so to the extent UK-based UCITS are marketed in the EEA, there is scope for disruption. In order to permit the continued marketing of non-UK based UCITS in the UK, the FCA will need to recognise these schemes in revised UK law (likely to be characterised as AIFs similar to their domestic counterpart, the non-UCITS retail scheme). UK managers should continue to be able to establish EU funds in financial centres such as Luxembourg, Ireland and Malta and provide investment management services to these funds from the UK under MiFID, as described below.
MiFID is of relevance to firms providing investment services other than as a fund manager, e.g. for managers operating bi-lateral mandates or providing other investment services (e.g. advising) to a separate AIFM or internally-managed AIF, and offers a pan-European passport allowing firms established in the UK to provide such services (either cross border or through a branch) throughout the EEA.
Although there is no ability currently for non-EEA based firms to access these passporting rights, the Markets in Financial Instruments Directive II (MiFID II) will (from January 2018) allow firms established outside the EEA (third country firms) under certain conditions to provide investment services directly to eligible counterparties and professional clients if they have been registered as a permitted third country firm, without having to establish a locally regulated branch or subsidiary. In order for a UK firm to benefit from these provisions once the UK has exited the EU the Commission would have to classify the UK as having a regulatory and supervisory regime equivalent to the EU’s supervisory regime, and ESMA must have established a cooperation agreement with the UK regulators. Assuming the FCA still implements rules equivalent to MiFID II, one would hope that both of these can be satisfied by the UK unless the political negotiations become hostile.
If the UK is recognised as a permitted third country firm under MiFID II, and firms wish to use the extended MiFID passport to provide services to funds established in third countries, they may need to amend their existing regulatory permissions to do so.
If the UK exits the single market it would no longer bound by the requirements to allow inward trade. However, we must assume from a financial and political perspective that the UK would continue to grant access to EEA-based funds and investment firms to market and provide services to UK based investors on a broadly equivalent basis to that enjoyed today. Brexit is not, therefore, anticipated to restrict the flow of capital into the UK market or the investment opportunities available to UK based investors to any significant extent.
Osborne Clarke comment
There is strong political will to defend the passporting rights of City firms and this exists across the political spectrum. Forfeiting these rights would restrict access to European capital and the activities of UK firms. That being said, existing funds-related legislation confers some of the benefits of passporting rights on certain third-country states. So if the UK is not granted single market access in the future, UK-based firms may still benefit from some equivalent passporting rights. Much will depend on the success of the UK Government in its negotiations.
For now, however, whilst it is important to plan for the future, fund managers should recognise that EU legislation continues to apply to UK investment firms in full and it is likely that it will continue to do so for several years.
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