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Brexit and ESMA’s Nine Principles

It’s an interesting time for Brexit negotiations and financial services firms. FCA Chairman John Griffith-Jones recently reported that the FCA was preparing for the “hardest of hard Brexits”. FCA CEO Andrew Bailey has said that he is discussing the possibility of transitional arrangements because of industry concerns with the Government.

But what does a hard Brexit mean in terms of financial services? It means the EU passport, under various pieces of EU legislation, which enables the setting up of branches and cross-border marketing of products and services in the EU[1] will no longer be available in some cases or will operate on a very limited basis in others. While there are some signs form Brussels that there may be limited scope for transition periods at the moment means that change to this situation could longer transitional periods, if there are not the change could be nasty, brutish and short for some businesses.

Third country territory

When Brexit happens, unless special arrangements are agreed, the UK will be treated as a “Third Country”, the same as any other non-EU Member State – it will no longer be part of the EU 27 Member States, or it seems the European Economic Area. The impact for some firms dealing with professional clients or in wholesale markets may be less acute than those dealing with retail clients. For example, under MiFID II[2], third countries assessed as equivalent may operate cross-border in dealing with per se Professional Clients and Eligible Counterparties. They will still need an authorised arm (branch or subsidiary) for any business conducted from an office in the country concerned, though a branch will also be able to passport to the same limited categories of clients. The AIFMD[3] passport (when it is eventually established) will only apply to Professional Clients but will be available to equivalent Third Country firms.

So, while this be painful for firms in the wholesale area, it may be possible to work with it – particularly as the UK (which has implemented all relevant EU legislation) must have at least a good chance of being rated as “equivalent”. There are difficult but limited transitional provisions which may allow some activities at least until equivalence has been assessed – and in practice there may be a longer lead-in time depending on how negotiations progress.

Retail

For those dealing with retail clients, there will be very few life jackets unless a special arrangement is made involving the UK. It may be possible to set up an authorised entity in an EU Member State or to establish branches in individual Member States where a firm intends to do business but these branches will not be able to passport to the EU27. The same restrictions will apply to firms dealing with Elective Professional Clients, including sophisticated, high net worth individuals who have asked to be treated as professionals, who will for these purposes be treated in the same way as the most unsophisticated retail clients.

So it may be a question of setting up an authorised firm in an EU Member State with passporting rights (for example a subsidiary) or ascertaining whether there are country-specific rules allowing for market access for particular products and services. There is some scope for individual Member States to apply their own rules in some areas but the approach of each individual EU27 country will be different. None of this will resemble an EU passport unless a specific authorised entity (not a branch) with passporting rights is set up in an EU 27 state.

The issue of setting up an authorised entity in an EU State is what makes The European Securities and Markets Authority's (ESMA) opinion on UK firms operating in the EU without a passport[4] particularly relevant at the moment.

The regulators in EEA member states have varied in the rigour with which they have approached applications for authorisation of “light” structures i.e. those which have a relatively small presence in the country concerned and rely on support from a head office or parent company elsewhere to perform important functions. The ESMA opinion can be seen as a warning in respect of such light structures. Pessimistically, it can be regarded as a stark warning that UK firms need significant and substantive resources in the main country where they want to do business before they can be authorised there. In other words, there will be no soft routes without a passport.

ESMA sets out nine principles applicable to local regulators (“NCA’s” or National Competent Authorities”) broadly summarized as follows:

1.No automatic recognition of existing authorisations.

Being FCA/PRA authorised won’t be enough.The UK will be treated as a Third Country like any other non-EU state. If a firm is seeking authorisation in the EU, it should approach the relevant NCA as soon as possible.

2.Authorisations granted by EU27 NCA’s should be rigorous and efficient.

Each NCA must have a tough authorisation process.

In considering an application by a UK firm or group member, NCA’s may have some regard for assessment by the UK regulators of (e.g.) fitness and propriety. NCA’s must still apply strong scrutiny to fundamental issues such as the firm’s governance, structure, human and technical resources, geographical distribution of activities, as well as delegating and outsourcing requirements.

There is a warning (repeated in several ways in different terms) about firms applying for authorisation “for the purposes of evading the stricter standards within the territory of which it intends to carry on the greater part of its activities”.

3.NCAs should be able to verify the objective reasons for relocation

Does the firm have a substantial reason for setting up in the EU –other than just getting a passport?

The programme of operations submitted with the application should give a clear justification for moving to the chosen Member State. This will involve questions such as:

  • (i)where will clients actually be?
  • (ii)what products and services will actually be offered where?

NCA’s must look at carefully at cases where another NCA has refused authorisation – or even simply where another NCA has been approached.

The application should not be part of a search for an easy jurisdiction, particularly where most of the business of the new firm will in fact be done elsewhere in the EU.

4.Special attention should be granted to avoid” letter-box entities” in the EU 27

Authorised firms must be real and substantial, not empty shells.

Letter box entities are shell companies with limited resources in the relevant Member State - most of the real functions of such a firm are performed elsewhere through outsourcing and delegation arrangements.

NCA’s should simply reject such applications where the real object is to get an EU passport.

5.Outsourcing and delegation to Third Countries is only possible under strict conditions.

NCA’s must look very carefully if a lot of the real work goes on in the UK (or other non-EU country).

The UK will be a Third Country.

Tasks or functions can be delegated in some cases, not responsibilities. A firm remains responsible for all tasks or functions delegated, and it must retain the ability (in the EU Member State where it is authorised) to direct or control the outsourcing or delegation.

6.NCAs should ensure that substance requirements are met

If functions are outsourced, there needs to be enough to supervise in the Member State where the firm is authorised – and access to outsourced IT facilities etc.

Outsourcing and delegation arrangements should be structured so that NCA’s can supervise them efficiently and effectively.

This requires;

comprehensive information from firms;

effective access by the NCA to all relevant data and the premises of the service provider (so for example visiting data centres unannounced);

no impact on business continuity, confidentiality and conflicts of interest which must continue to be effectively managed.

Certain key activities which are key to the proper functioning of the firm cannot be delegated outside the EU. This includes substantive decision-making – which the EU authorised firm must continue to be able to make.

Special scrutiny must be given by NCA’s to key functions such as internal audit; IT control; risk assessment; compliance; key management function. In some cases it may not be possible to delegate these at all outside the EEA. They should always be available for close supervision by the NCA.

7.NCA’s should ensure sound governance of EU entities.

There must be real decision-making and management in the EU State where the firm is authorised.

Board members and senior managers in the EU need to have effective decision-making powers in relation to compliance with EU law, even where the firm is part of a larger group.

Key executives and senior managers should work in the EU to a degree proportionate to their role (though it is conceded that with small firms some functions may not involve full time roles).

This means that the firm must maintain a sufficient presence of executive board members and senior managers with sufficient knowledge and experience wo can dedicate sufficient time to their jobs.

Firms should have adequate levels of liquidity and own funds which are readily available to them in the EU Member State.

8.NCA’s must be in a position to effectively supervise and enforce EEA law.

NCA’s themselves must have enough resources.

NCA’s themselves should have adequate resources and capacity to monitor the effective application of the relevant EU legislation and respond to market developments and to supervise authorised firms.

They must ensure that initial conditions for authorisation are met on a continuous basis including those relating to outsourcing and delegation. This means that they must be able to conduct on-site investigations of outsourced and delegated activities without any third party authorisation. They must ensure that they have sufficient information to perform their role. Co-operation between EU NCA’s will be crucial.

9. Coordination to ensure effective monitoring by ESMA.

There will be a framework for co-operation to ensure consistency between EU27 states.

ESMA will establish convergence tools including Supervisory Coordination Network for EU27 NCA’s. This Network will promote consistent decisions by NCA’s. Authorisation and enforcement remain, however, within the powers of the NCA’s.

ESMA will be ready to support the Network through follow-up work including bringing cases, providing opinions to NCA’s, conducting peer reviews and initiating investigation of possible breaches of EU law.


What should firms do?

How the Brexit negotiations will turn out is at best unclear to the industry (and perhaps also to the negotiators). The worst case could be fairly negative for some firms who rely, to a significant extent, on EU business – unless a special arrangement is made. It is useful at least to consider options for the worst case scenario and so:

  1. Scope how much the firm relies on business in the EU or EEA, analysing the type of business and the basis on which it is done in the EU and the EEA.
  2. Consider how much this may be affected by the hard financial services Brexit scenario outlined above – some products and services are outside EU Directives and are subject to individual laws of Member States.
  3. Consider contingency options which may include an authorised presence or a co-operation arrangement with an EU-regulated firm or firms.
  4. Hope that it all turns out better than this – there is a possibility of a longer lead-in time but nothing definite as yet.



[1] Additionally within the European Economic Area – I have only dealt with EU countries because that is the focus of ESMA’s opinion.

[2] Shorthand for the MiFID II Directive (2014/65/EU) and the Markets in Financial Instruments Regulation (Regulation 600/2014) (MiFIR)

[3] The Alternative Investment Fund Managers Directive (2011/61/EU)

[4] “General Principles to Support Supervisory Convergence In the context of the UK withdrawing from the EU

UK https://www.esma.europa.eu/file/22279/download?tok...

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This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.

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