This article has been prepared by Grania Baird and Kya Fear and is being circulated as an update to the “Brexit and Financial Services” series of articles: “Brexit and Financial Services: The Final Countdown” which is available here and subsequently “Brexit and Financial Services: deal or no deal?” which is available here.
We now have fewer than 50 days for the United Kingdom (UK) and the European Union (EU) to reach agreement on the terms the UK will exit the EU. With a deadline of 29 March 2019 (Exit Day) fast approaching, firms’ contingency plans are focusing on a possible no deal outcome.
In this article, we provide you with an update on Brexit developments with a particular focus on the investment management sector.
What is Plan B?
On 29 January 2019, Theresa May presented the skeleton of her Plan B to MPs and has convinced MPs that she should have the opportunity to seek to renegotiate the Withdrawal Agreement with the EU. Pursuant to section 13(1)(b) of the European Union Withdrawal Act 2018, the UK Government needs the House of Commons to approve the Withdrawal Agreement and the Political Declaration, otherwise and unless the deadline of 29 March 2019 imposed under Article 50 is extended, the UK will exit the EU without a deal with the EU in place.
A key issue in negotiations is the so-called Irish border “backstop” included in the draft Withdrawal Agreement which is meant to prevent a hard border between the Republic of Ireland and Northern Ireland by keeping the UK in the EU customs union unless and until both the UK and the EU agree “alternative arrangements” to a hard border (such as technology-based customs system) are sufficient. It is strongly opposed by Eurosceptics on the basis that they fear it will bind the UK into the EU’s customs union indefinitely. On 29 January 2019, Sir Graham Brady’s amendment which called for “alternative arrangements” to replace the backstop in the Withdrawal Agreement passed and the UK Government now has a short window to return to the House of Commons with a more detailed Plan B, which would presumably need to include changes to the backstop (potentially either a unilateral exit mechanism or a time limit) and new guarantees to maintain workers’ rights.
Dame Caroline Spelman’s amendment was also approved by the House of Commons – this amendment rejected a no deal exit from the EU but, importantly, it did not legally oblige the UK Government to avoid one. In other words, a no deal is still a possibility.
What contingency planning is the UK undertaking?
In a previous article, available here, we explained that the UK Government is preparing for a scenario where the UK leaves the EU without a deal and without a transition period by, amongst other things, issuing statutory instruments to ensure that the UK has a fully functioning financial services regulatory regime as at Exit Day, even in a no deal scenario (so-called Onshoring Regulations). Amongst other things, the Onshoring Regulations provide for a temporary permissions regime (TPR) so that after exit, providing the relevant temporary permission has been applied for, firms who currently provide services to the UK via a passport will be able to continue to do so and UK investors will have continued access to EU funds that were marketed in the UK prior to Exit Day, for a temporary period.
Of particular note, since the publication of our last article, HM Treasury has:
- Allowed for new sub-funds to enter the TPR: HM Treasury updated the Draft Collective Investment Schemes (Amendment etc.) (EU Exit) Regulations on 12 December 2018 (UCITS Brexit Regulations) so that where an existing EU umbrella fund has permission under the TPR to service UK clients, its new EU UCITS sub-funds created on or after Exit Day can also apply to enter the TPR. New sub-funds are defined as those which become authorised in accordance with the UCITS Directive by their National Competent Authority (NCA) either on or after Exit Day.
- Established a financial services contracts run-off regime: HM Treasury published the Draft Financial Services Contracts (Transitional and Saving) Provision Regulations 2019 on 15 January 2019 which enables EU firms that do not enter the TPR, or exit it without full UK authorisation, to continue meeting their existing contractual obligations in the UK for a limited period after Exit Day. This allows them to wind down their obligations in an orderly manner or transfer business to a regulated UK entity as necessary.
- Launched a new inquiry into the future of financial services: On 25 January 2019, the House of Commons Treasury Committee published a press release announcing the launch of a new inquiry into the future of financial services in the UK after Exit Day. It will consider what the UK Government's financial services priorities should be when negotiating the UK's future trading relationship with the EU and third countries. Nicky Morgan, Committee Chair, commented that the UK may converge, seek equivalence, or diverge from the EU and the Committee will examine the risks and rewards of each of these choices.
- Published Draft Money Market Funds (Amendment) (EU Exit) Regulations 2019: This Onshoring Regulation seeks to amend the EU Regulations on money market funds ((EU)2017/1131) which will be retained EU law (MMF Regulations) to ensure that the regime operates effectively in the UK after Exit Day. It amends the MMF Regulations’ scope so that it applies only within the UK and requires that the manager of a money market fund is established in the UK. It also allows for money market funds that have a temporary marketing permission under the UK’s TPR to be able to be marketed for the duration of the TPR – after this time, they should either be recognised under section 272 of the Financial and Services Markets Act 2000 (FSMA) or notify under the UK’s national private placement regime.
- Published Draft Financial Services and Markets Act 2000 (Amendment) (EU Exit) Regulations 2019: This statutory instrument would amend those provisions of FSMA which are dependent on provisions in EU legislation, such as definitions that are originally found in EU law or are based on activity being carried out within the EU. Regulation 39 notes that the Financial Conduct Authority (FCA) may make rules applying to authorised persons in relation to communications by or approved by them if the FCA considers such rules are required to ensure compliance with certain “listed requirements”. This Onshoring Regulation goes on to explain that “listed requirements” mean requirements that appear to the FCA to correspond to the requirements of various EU legislation, including MiFID II and the UCITS Directive.
Are there any particular issues we should be aware of concerning the Onshoring Regulations?
The Financial Markets Law Committee (FMLC) has been reviewing the Onshoring Regulations. Most recently it wrote a letter to HM Treasury setting out that HM Treasury’s definition of “listed requirements” in the Draft Financial Services and Markets Act 2000 (Amendment) (EU Exit) Regulations 2019 is very uncertain, and a more specific list would be more useful. The FMLC has also specified a number of legal uncertainties concerning the draft statutory instruments onshoring the AIFMD and UCITS regimes. Some of the issues spotted by the FMLC were addressed in the most recent updated drafts of those Onshoring Regulations published on 12 December 2018, however, some remain.
The uncertainties that remain relate to: (i) references to other legislation, (ii) temporary marketing provisions for funds, (iii) delegation of AIFM functions, (iv) transfer of functions to HM Treasury, and (v) temporary recognition of UCITS. The uncertainties are detailed in the drop-down box below.
Uncertainties in the Onshoring Regulations concerning AIFMD and UCITS
1. References to other legislation
- The Alternative Investment Fund Managers (Amendment) (EU Exit) Regulations 2018 (AIFMD Brexit Regulations) seeks to freeze the law at two points in the future to allow firms to plan for a post-exit no deal scenario. The first freezes references to domestic law and EU regulations, decisions or tertiary legislation referred to in the Alternative Investment Fund Managers Regulations 2013 so that these are read as references to the law “as it has effect on the day on which the Alternative Investment Fund Managers (Amendment) (EU Exit) Regulations 2018 are made”. This begs the question as to how the UK will take into account any changes in EU law made in the interim between the day the statutory instrument is made and Exit Day.
- The second point freezes references to sourcebooks published by the FCA – these are to be taken as they have “effect on exit day” in both the AIFMD Brexit Regulations and the UCITS Brexit Regulations, therefore when there are updates to sections of the FCA’s Handbook, a new statutory instrument may be required to correct the references. This carries potential legal and operational uncertainty. The FMLC recommended that the FCA and HM Treasury consider how subsequent updates to guidelines and rules will be reflected in the AIFMD Brexit Regulations and the UCITS Brexit Regulations.
2. Temporary marketing provisions for funds
- The TPR set out in the AIFMD Brexit Regulations provides that an EU AIFM is to be treated as an authorised person if it satisfies certain criteria, including, if immediately before Exit Day it “was marketing” an EU AIF, UK AIF or third country AIF in the UK in reliance on Article 32 and Article 36 of AIFMD. It is not clear whether this requires an EU AIFM to be actively marketing to be deemed authorised. The FMLC noted that clarifications on these conditions would be helpful for firms planning for a no deal exit.
- It is not clear in the AIFMD Brexit Regulations when the TPR period will end since “after three years beginning with the day on which exit day occurs” is open to interpretation. The last day of the relevant period might be either 28, 29 or 30 March 2022, and since the period ends “after three years”, this could on a literal reading mean any time after that date. The FMLC suggested that the provision should be updated to read “on the third anniversary of exit day”.
- Finally, it appears from HM Treasury’s policy intention that the TPR will apply to “EEA funds and AIFMs”, and in line with that policy, there is no provision in the AIFMD Brexit Regulations for UK AIFMs marketing EU AIFs in the UK. Such AIFMs will have applied for FCA approval to market these AIFs under Regulation 54 of the Alternative Investment Fund Managers Regulations 2013 (they will not have applied for approval under Regulation 57(1) which covers marketing of third country AIFs). UK AIFMs may therefore need to reapply for permission to market an EU AIF under revised Regulation 57 of the Alternative Investment Fund Managers Regulations 2013.
3. Delegation of AIFM functions
- The AIFMD Brexit Regulations amends provisions in relation to the delegation of AIFM functions, however, it does not make clear whether existing delegation arrangements which are in place at exit will be grandfathered or whether these will have to be reappraised.
- Further, the AIFMD Brexit Regulations requires that where the delegation concerns portfolio management or risk management and is conferred on a third-country undertaking, that cooperation between the FCA and the Member State NCA of the undertaking is ensured. As noted below, the FCA has agreed a multilateral memorandum of understanding which will allow certain activities, including delegation, to continue to be carried out by UK firms on behalf of EU firms.
4. Transfer of Functions
- The AIFMD Brexit Regulations inserts Article 69A into the AIFM Regulations 2013, bestowing upon HM Treasury the ability to make subsequent statutory instruments so as to discharge its new functions. The new functions range from the specification of registration obligations for small AIFMs, control and safeguard arrangements for electrical data processing and adequate internal control mechanisms which AIFMs are required to have. Market participants have apparently raised some concerns that such new statutory instruments might be too cumbersome in light of the pace at which new market practices and products emerge.
5. Temporary recognition of UCITS
- The UCITS Brexit Regulations also provides for a TPR in respect of EU UCITS. At the end of the TPR, a UCITS operator would need to apply under section 272 of FSMA for the UCITS to become a recognised collective investment scheme in order for it to be offered to retail investors in the UK. However, at the end of the TPR, it is not clear whether the UCITS would then become an AIF and whether the UCITS management company would then be considered to be managing an AIF such that it will need to vary its FCA permission.
- There was a further concern raised by the FMLC about whether UCITS which have been granted temporary recognition may continue to be exempt from the PRIIPs Regulation (which is now expected to be applicable vis-à-vis UCITS in 2021). FMLC suggested that a statement from the FCA on the way the TPR and section 272 FSMA regimes will function consecutively would help ensure legal certainty.
- Only seven umbrella funds have been granted recognition under section 272 of FSMA to date. The UK Government has acknowledged that the regime is not fit for granting recognition where a high volume of applications may be received at any one time, it is therefore undertaking a review of the regime. At this stage, it is uncertain how that regime will operate
Will cooperation agreements between the FCA and Member States’ NCAs be in place before Exit Day?
The absence of cooperation agreements was a key “cliff edge” risk for the asset management industry. As set out in our first article in the series (available here), the UK is a key provider of investment management services, which are often provided to firms (including European firms) on a delegated basis. If the UK exits the EU without a deal and without a transition period in place, it will automatically be treated by the EU as a third country on exit and therefore in order for EU firms to outsource or delegate portfolio management to UK firms under AIFMD, MiFID II and/or UCITS, and for UK AIFMs to market AIFs in Member States under Member States’ national private placement regimes, cooperation agreements (or memoranda of understanding) must be in place.
The FCA announced on 1 February 2019 that it has now agreed:
- a multilateral memorandum of understanding between EU securities regulators and the FCA covering supervisory cooperation, enforcement and information exchange between individual regulators and the FCA, which will allow them to share information relating to, amongst other things, market surveillance, investment services and asset management activities (in turn, this allows for certain activities such as outsourcing and delegation to continue to be carried out by UK firms on behalf of firms based in the EU), and
- a memorandum of understanding with ESMA covering supervision of credit rating agencies and trade repositories.
Will we need equivalence decisions prior to exit?
If the UK leaves the EU without a transition period, existing passporting rights enabling UK firms to operate a branch or provide services on a cross-border basis into the EU will cease on Exit Day. The UK will become a third country. Some EU legislation provides for third country firms to gain access to EU markets where the third country’s regulatory regime has been deemed “equivalent”.
The concept of equivalence features in MiFID and AIFMD. With respect to MiFID, if equivalence is granted in respect of the UK, UK firms will, subject to certain other conditions, be able to provide cross-border services into the EU to eligible counterparties and per se professional clients. With respect to AIFMD, where AIFs are marketed to per se professional clients in the EU there is the possibility of extending the passport to non-EU AIFMs based on “positive advice” from ESMA (however this third country passport regime has not yet been “switched on”). For completeness, there is no equivalence assessment in the UCITS Directive. Equivalence assessments in a broader context (ie not linked to passporting) are relevant in other European Directives, for example, under the Capital Requirements Regulation and to the European Markets Infrastructure Regulation (EMIR).
In theory, given the current regulatory framework of the UK, which derives from EU law, it should be straightforward for the UK to be deemed equivalent. However, the decision is subject to political consideration at the EU level.
ESMA has communicated that its Board of Supervisors supports continued access to UK central clearing counterparties (CCPs) and to the UK central securities depositary (UK CSD), to limit the risk of disruption in central clearing to avoid any negative impact on the financial stability of the EU. ESMA is aiming to recognise UK CCPs and the UK CSD in a timely manner, where the four recognition conditions under Articles 25 of EMIR and the CSDR, respectively, are met.
The first condition is that the European Commission has adopted implementing acts to determine that the legal and supervisory arrangements of third parties are equivalent to the requirements laid down in EMIR and CSDR, respectively. To that effect, on 19 December 2018, the European Commission announced temporary equivalence decisions that would become effective following a hard exit and would provide for a 12-month temporary equivalence determination for UK CCPs and a 24-month equivalence determination for the UK CSD. For UK CCPs, the equivalence decision is not limited to the clearing obligation but covers any clearing services offered by a UK CCP to EU clearing members and venues. Likewise, the equivalence decision for UK CSDs is a wholesale equivalence decision to allow for uninterrupted access after Exit Day for a temporary period. The third condition relates to cooperation arrangements being in place. On 4 February 2019, the third condition was met by ESMA and the Bank of England concluding memoranda of understanding for the recognition of UK CCPs and UK CSDs established in the UK – the memoranda of understanding will take effect should the UK leave the EU without a withdrawal agreement. ESMA has said that it aims to complete next steps for recognition of UK CCPs and the UK CSD and adopt recognition decisions well ahead of Exit Day. These recognition decisions would take effect on the day after Exit Day.
The equivalence decisions relating to EMIR and CSDR do not set a precedent on equivalence for the UK during a transition period with the UK, should there be one. Further, industry bodies have raised concerns that they do not cover UK trading venues. Under MiFID / MiFIR, the UK would need to be deemed equivalent by the EU, and UK trading venues would need to be recognised by ESMA for certain trades to be executed through UK venues. The impact of no equivalence decision being made before Exit Day may depend on a firm’s broker’s ability to segment trading into “EU” and “non-EU” trading and the Investment Association is encouraging the buy side to encourage their brokers to prepare for a no deal and no equivalence exit scenario.
With respect to the UK’s efforts, on 17 January 2019, HM Treasury published a draft version of the Equivalence, Determinations for Financial Services and Miscellaneous Provisions (Amendment etc) (EU Exit) Regulations 2019, the purpose of which is to make provisions for elements of the UK equivalence framework to ensure that they function effectively in the event of a no deal exit. They provide the UK Government with a temporary power, for up to twelve months after Exit Day, to make equivalence decisions for EU Member States quickly and efficiently to support UK market activity and the continuity of cross-border business. After this power expires, and for any counties outside the EU, equivalence decisions made by HM Treasury must be made by regulations subject to the “negative procedure”, a type of Parliamentary procedure that applies to statutory instruments.
Schedule 1 of the Equivalence, Determinations for Financial Services and Miscellaneous Provisions (Amendment etc) (EU Exit) Regulations 2019 sets out EU legislations under which HM Treasury will make equivalence decisions for EEA states by direction and includes, amongst other things, MiFID, the Prospectus Directive and the Benchmarks Regulation.
Are EU Member States doing anything to provide transitional relief?
Although the EU has not provided for an EU wide temporary permissions regime, we understand that a number of EU Member States (for example Italy, France, Germany, Ireland and Finland) have indicated that they intend to introduce measures (of varying types) should a no deal exit arise to provide transitional relief for financial market participants.
What should firms be doing?
With fewer than fifty days before Exit Day, and no agreement on the terms of withdrawal and therefore no certainty over whether a transition period will apply, firms should continue to plan for an exit with no deal in place. If firms have not done so already, they should also have a communication strategy for clients in light of Brexit and potential implications.
Firms should also be considering their relationships and contracts with third party service providers to ensure there will be minimum impact on the services those third parties provide to firms after Exit Day.
Finally, firms should be keeping a close eye on any new or updated Onshoring Regulations to determine whether they are required to take any actions pursuant to these before Exit Day and should be keeping up to date with statements released by the regulators.
What has the FCA been saying recently?
Most recently, the FCA released a statement on 1 February 2019 available here explaining what it expects firms and other regulated persons to be doing in relation to Brexit. In this, the FCA noted (amongst other things) that firms and regulated persons should begin now to comply with changed obligations in respect of transaction reporting under MiFID II. From Exit Day, the UK’s transaction reporting regime will change. The FCA has published a new webpage available here on transaction reporting and its new system for validation and publication of instrument reference data. The webpage explains what firms need to do to prepare for exit. Firms will be able to test the new system from 21 February 2019. The FCA also noted that firms and CCPs who enter derivatives transactions in scope of EMIR will be required, from Exit Day, to report into a UK-registered trade repository.
Helpfully, the FCA has said that it expects firms to take reasonable steps to comply with their regulatory obligations by Exit Day, and that it will act proportionately and will not take a strict liability approach in a no deal scenario.
The FCA is expected to publish more information before Exit Day on how firms should comply with post-exit rules.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, February 2019