UCITS

Theresa May has now triggered the UK’s article 50 notification to exit the European Union (“EU”), raising the very real risk of the loss of passporting rights. This could have severe implications for all sectors of the financial services industry, which have evolved around the use of the passport.

Looking to the asset management sector, the loss of passporting rights would prevent EU-domiciled UCITS funds from using UK fund managers. In addition to the operational disruption, the underlying service agreements may not be easily terminated without significant costs. UK-domiciled UCITS funds would be re-classified as alternative investment funds and lose their rights to be marketed to retail consumers across the EU. The affected fund management groups would now need to comply with the Alternative Investment Fund Management Directive, whose provisions are very different to the UCITS Directive. A shift to a new set of regulations is bound to be costly and time-consuming.

Another concern is that UCITS funds are only allowed to invest up to 30% of net asset values in non-UCITS funds. In light of the UK’s third-country status, fund mandates would need to be reviewed and investment strategies adjusted with the potential for further costs and crystallised losses for retail investors.

The potential restructuring driven by a cliff-edge Brexit will fragment the pan-European business model, reduce profits, lead to sub-optimal capital allocation and trapped liquidity. It will also introduce a wider range of potential consumer protection, legal, operational, financial stability and market integrity risks.

Regulatory Equivalence

Regulatory equivalence has been mooted as a panacea to these problems. Equivalence is an assessment of a third-country’s legal, regulatory and supervisory framework to determine that it is broadly equivalent to the EU’s.

The European Commission is responsible for decisions on equivalence, supported by technical advice from the European Supervisory Authorities. In theory, this should not present any problems for the UK as its currently regulatory framework is derived from the EU’s.

However, equivalence provisions are set out in individual European Directives rather than any overarching provisions. Thus, they are tailored to the specific scope, needs and objectives of a particular Directive. Each Directive sets out a range of conditions and criteria for a jurisdiction to be deemed equivalent. Some of these conditions may concern issues broader than the subject matter of the Directive, such as tax regimes or professional secrecy.

Crucially, a number of Directives contain no equivalence provisions, such as the UCITs Directive. Others limit the scope, such as the Capital Requirements Directive, which offers prudential benefits but would not permit provision of banking services.

Reliance on equivalence provisions is, therefore, sub-optimal because they were developed in a fragmented and piecemeal way. They do not offer the same level of access currently enjoyed and could be revoked at any time. Thus equivalence is the swapping of an enshrined legal right for a privilege that is granted subject to certain conditions with an uncertain tenure.

Despite the scope of provisions being set out in each Directive, the EU may attach additional conditions or requirements to its decision. These could range from:

Placing specific conditions or requirements on the third-country;
Limiting its scope to specific types of entities, products or services; or
Permitting it for a fixed period of time only.

The assessment should theoretically be a technical assessment but political imperatives may intervene. The equivalence provisions were never drafted with the UK in mind. Withdrawal will result in a significant concentration of EU financial activity occurring outside of its jurisdiction that could be a potential threat to its financial stability. The EU would certainly respond by adapting its regulatory framework to ensure that it can control and react to systemic events if this was the case.

Transitional Arrangements

A new framework will need to be agreed and, in the interim, transitional arrangements will be required. Transitional arrangements provide a bridging period to enable firms to understand future rights and obligations and to plan appropriately. They are normally agreed towards the end of the process when there is clarity about the framework. This would, however, be too late for firms as it takes time to recalibrate business models, novate client contracts or shift operations to new locations.

Assuming a new framework could not be agreed within two years, Brexit-related transitional provisions would serve the twin purpose of maintaining the status quo and facilitating a smooth transition to a new regime. To reduce the uncertainty, the UK government could seek early on in the negotiations some form of pre-emptive or provisional equivalence with the EU. However, any transitional arrangement would need to overcome the political paradox that the purpose of Brexit is to put an end to EU regulation, restrict freedom of movement and extinguish the jurisdiction of the European Court of Justice.

The EU referendum was a historic moment for the United Kingdom (“UK”), heralding a new relationship with the European Union (“EU”). Questions remain as to what the mantra ‘Brexit means Brexit’ actually means. Ultimately, it will boil down to a question of trade-offs between control on immigration and access to the single market.

Whilst this plays out at the political level, what are the implications and potential impacts for UK financial services firms in the event of a Brexit entailing no access to the single market?

Cross-border matters

The loss of the passport has received the most media attention. In my own experience, the passporting system is far from perfect but its removal will impair cross-border business. With Brexit, the UK will become a third member state and firms wishing to undertake cross-border business will need to establish separately capitalised and authorised legal entities within another EU State. This will introduce further costs and create additional complexity.

UCIT funds will also be impacted. The UCITs Directive currently permits fund managers and fund administrators to be located in a different EEA state to where the fund is domiciled. If this arrangement ceased, UCITs funds with UK managers and administrators would need to be restructured and / or re-domiciled. This would reduce the scale economies from operating on a pan-European basis and will feed through into costs, profitability and fund charges.

EU-domiciled UCITs funds would also lose their right to be distributed in the UK and, therefore, be re-classified as unregulated or alternative funds. Current regulations prohibit sale and marketing of these funds unless an exemption applies. In reality, one would expect the FCA to introduce some form of recognition and / or grandfathering to ensure continuity for investment advisers and clients.

Squaring the cross-border circle

Regulatory equivalence has been mooted as a potential solution for UK firms wishing to operate on a cross-border basis. Regulatory equivalence would permit the UK to access the single market if it can demonstrate equivalent regulatory standards with the EU. As the UK has been operating to these standards already, this should be entirely feasible.

However, in practice, this may be onerous because requests for equivalence require vetting by the relevant European Regulatory Authorities and subsequently by the European Commission.

One of the key problems is that there is no time-scale for this process to be completed. Equivalence also has an uncertain tenor because it could easily be revoked if, for example, the UK’s regulatory framework begins to diverge from the EU’s in the future. A decision to dilute the remuneration code, for example, could trigger such a move.

A corporate structure called a Societas Europae (“SE”) could be the solution. A SE is a company registered in accordance with the law and corporate governance standards of the EU. It enables the transfer of registered offices across member states. With the UK currently a member of the EU, conversion to a SE would allow transfer of the company to a new EU state. However, this is still not a simple task as full authorisation would be required in the new EU state. Additionally, sales and back-office staff will also need to migrate to avoid tripping the EU regulatory perimeter, adding a human capital dimension to the issue.

Conduct of Business and Consumer Protection

With a full withdrawal from the single market, could this open up opportunities to reduce the regulatory burden and simplify the conduct of business rules?

The FCA’s conduct of business rules are predominantly derived from its consumer protection objective. The rules are designed to encourage good business practice, promote good governance and improve the ability of consumers to make buying decisions. It is difficult to envisage the FCA concluding that withdrawal from the EU means that consumers now need less protection. At the 2016 FCA annual public meeting, Andrew Bailey stated, “We don’t expect to be distracted from our regulatory obligations, our objectives will not change and, as such, no one should expect a bonfire of regulation”.

One of the factors hampering simplification is the interplay between EU law and regulation and our own. EU directives are transposed into UK law whereas EU regulations are implemented without transposition. With Brexit, EU directives will remain in place whilst EU regulations will fall away. Consequently, there will need to be substantive reviews of the existing regulatory framework to minimise disruption and ensure continuity as highlighted with the example of UCITs. This is a substantial undertaking unlikely to confer any net new benefits to either the FCA’s consumer protection objective or firms.

What next?

Until we know what “Brexit means Brexit” actually means, it is still too early to predict the precise impact for firms and it is important to note that there will be a reciprocal impact on EU firms passporting into the UK.

For those operating on a cross-border basis, the uncertainty will be too great and they will re-locate or change existing business models. For other firms without this impetus, they should start evaluating different operating models and explore EU states to operate from – an analysis that will need to consider a much broader set of factors such as labour laws and tax regimes.

For domestically-focused firms, the regulatory framework remains the same. Current and future EU regulations must be adhered to and, in the event of Brexit-driven changes, one would expect a transitional period before the new framework comes into force.

Whatever the outcome of the negotiations and whoever are the winners and losers from Brexit, we can see the path ahead will be littered with both uncertainty and challenging decisions.

Written by Esrar Moitra

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