_Today marks four years since the one of the most divisive moments in Europe politics – the decision of the UK electorate to leave the European Union. The intervening period has been one of significant global change, but ultimately unproductive from the perspective of agreeing a future relationship between the UK and the EU. On 12 June 2020, the UK government notified the EU that it did not intend to request an extension to the transitional period under the withdrawal agreement, reducing the amount of time left for the EU and UK to agree a post-Brexit deal to six months, making a no-deal Brexit more likely.
Since opening our London office in June 2018, we have tried to avoid speculating on the outcome of political negotiations regarding Brexit, and just approached it from the perspective of what the minimum or worst-case outcome would be for UK firms: providing services on a cross-border basis into the EU1 as a third country.
Going back over notes and presentation slides from two years ago, it is disappointing to see that the only development in the provision of financial services from the UK post-Brexit has been the multilateral memorandum of understanding between the European Securities and Markets Authority (ESMA) and the Financial Conduct Authority (FCA), although it should be noted that this was not a win, as these cooperation agreements are agreed between national competent authorities, and so could not have been a subject of the political negotiation in any event. As such, it was always safe to assume that there would have been a cooperation agreement in place between the Commission de Surveillance du Secteur Financier (CSSF) and the FCA.
That is not to say that progress can’t be made in the next six months, but it should be noted that the deadline to reach agreement on financial services equivalence was set at 30 June 2020. Considering this, a no-deal scenario on cross-border financial services from 1 January 2021 seems likely.
Let’s consider what this means in practice for UK-based fund managers, taking fund management first, then looking at distribution.
Here we are looking at new fund launches, where a UK fund manager wishes to establish an EU-based fund, whether in order to allow it to be more freely distributed within the EU or to minimise tax leakage in the investment structuring.
To facilitate onward distribution, the fund management activities must be undertaken within the EU by a duly authorised entity, being a management company of a Undertaking for Collective Investment in Transferable Securities (“UCITS”) or self-managed UCITS, regulated AIFM or sub-threshold registered AIFM. The regulatory status of the management entity is important in determining whether-or-not portfolio management can be delegated to the UK as a third country. The ability to delegate to an entity in the UK is also dependent on the entity in the UK being an FCA regulated firm or an appointed representative of an FCA regulated firm.
As such, UK portfolio managers will be able to provide portfolio management services as delegates of regulated entities in Luxembourg (or elsewhere in the EU). Typically, these structures utilise third party AIFMs or UCITS management companies as regulatory umbrellas that oversee duly authorised entities in permitted third countries, although larger managers that are able to satisfy the critical mass necessary to support the substance and cost requirements of having their own managers may do so and then onwardly delegate portfolio management to the UK or elsewhere.
Where a manager wishes to avail itself of the less regulated sub-threshold framework under the Alternative Investment Fund Managers Directive 2011/61/EU of 8 June 2011 (“AIFMD”) for smaller AIFMs and AIFs, it should be noted that portfolio management cannot be delegated by the sub-threshold registered AIFM. However, the AIFM may be able to establish an advisory relationship with a UK entity. Given the need to retain decision making at the level of the registered AIFM, we would typically see this used for smaller funds in less liquid strategies where investment decisions are made less frequently, such as venture capital, private equity or real estate, with the fund’s general partner being designated as the sub-threshold registered AIFM. However, it should be noted that such sub-threshold AIFMs are not able to avail themselves of the marketing passport under AIFMD, so EU distribution will only be permitted on a limited private placement basis.
It should be noted that if a portfolio manager wishes to provide segregated portfolio management to a client within the EU, this will be captured under the Markets in Financial Instruments Directive or Regulation (“MiFID” or “MiFIR” as applicable), so the requirements discussed below would apply.
Finally, for completeness, it should be noted that the Luxembourg legislature provided for the possibility of a limited transitional period for existing funds, including up to 21 months from the UK’s departure date from the EU for UK Alternative Investment Fund Managers (“AIFMs”) of Luxembourg Alternative Investment Funds (“AIFs”) (the law dated 8 April 2019 resulting from the draft bill of law n°7401), but prior registration was required for firms to be able to take advantage of the transitional provisions. We covered these provisions in a previous article ("Luxembourg Financial Sector Amendments for a No-Deal Brexit").
Distribution of funds in the EU is a complicated business, and whilst there have been legislative measures to address this issue (see below), it is important to understand the nuanced issues and some of the background challenges, particularly as they relate to Brexit.
The first point to note is that for UCITS, with the limited exception of execution-only distribution, distribution will fall under MiFID and/or MiFIR. This is because they will be considered to include an element of advice, such as where a range of funds are on offer. Similarly, while AIFMD includes a manager distribution passport, if a range of funds is on offer, or if the promoter offers the opportunity to invest through a managed account (being a MiFID service), these promotional activities could be caught under MiFID and/or MiFIR. Fund promoters should always be clear of their objectives and scope of activities to ensure that they have sufficient regulatory coverage.
Where distribution activities include an activity that is captured by MiFID/MiFIR
As a starting point, in the same way that a UK firm could establish its own management entity within the EU (above), it could also establish its own MiFID distribution entity. However, there would be significant staff and capital costs to achieve the necessary substance.
Alternatively, in order for such services to be provided by third country firms, not only is a cooperation agreement required (see above), but ESMA has to make an equivalence determination in relation to the country in question. To date, there have been no such determinations made for third countries, including the UK, despite it being having fully-integrated MiFID and MiFIR into its regulatory system (known as day 1 equivalence). This point is fundamental to the post-Brexit provision of financial services on a cross border basis from the UK, but at this stage we will assume that there will be no deal on Brexit and therefore no equivalence.
Even assuming an equivalence decision was made, in the absence of any change to the current market access rules for UK firms, they will face additional barriers to the EU fund distribution market. These barriers depend on the classes of investors that they seek to access for retail clients and elective professional clients, a UK firm would need to establish a branch under Article 35 of MiFID. Alternatively, accessing per se professional clients or eligible counterparties would be possible on a cross-border basis from the UK if the firm in question was registered with ESMA (a process that would be expected to take up to six months).
In the absence of any agreement or relief measures, it is therefore most likely that UK firms wishing to distribute funds in the EU where such distribution is captured by MiFID, will do so via third party placement agents or distributors, or otherwise through regulatory umbrellas where they are permitted within the EU.
Distribution activities falling outside MiFID/MiFIR and the Cross-Border Distribution Directive
As mentioned above, non-advisory distribution of an AIF (and no promotion of a segregated account) by its AIFM will fall under the AIFMD. Where these activities occur on a cross-border basis within the EU, the AIF will have to be passported under the manager passport (see below). The regulatory responsibility for compliant distribution will fall on the AIFM, so it will have to be careful to ensure that its distribution activities are conducted correctly and do indeed fall within AIFMD and not MiFID/MiFIR. In practice, this should be reflected in oversight of any involvement of the third country portfolio management, and the AIFM will expect to have oversight of -and involvement in- these activities, which will have significant cost implications.
Execution-only distribution of a UCITS will also fall outside MiFID or MiFIR, although this is rare in practice.
Whether in-scope or not, the cross-border distribution regime for UCITS and AIFs is changing. To date, the distribution regimes have been hampered by a lack of alignment between member states and certain additional barriers to entry. The lack of harmonisation has been addressed by Directive 2019/1160 of 20 June 2019, commonly known as the “Cross-Border Distribution Directive”, which must be implemented into member states’ law by 2 August 2021. While the Cross-Border Distribution Directive has a number of very positive impacts on the approach to cross-border distribution of funds within the EU, it introduces additional regulatory challenges for firms that are considering launching an AIF and conducting pre-marketing activities, and these will be compounded for third country portfolio managers.
In summary, where a firm is considering launching an AIF and sounding-out investors, this activity will constitute “pre-marketing” that will have to be notified to the AIFM’s home state regulator within two weeks of this pre-marketing having commenced. The letter will need to specify where and for what period the pre-marketing is taking or has taken place, with a brief description of the pre-marketing and investment strategy of the proposed AIF.
For third country portfolio managers considering an EU AIF, they will therefore have to appoint an AIFM for the purposes of complying with the regulatory requirements for pre-marketing before they sound-out investors.
What about reverse solicitation?
There are limited circumstances in which legitimate reverse solicitation is permissible. However, managers should not rely on it to form the basis of a distribution strategy. Reverse solicitation is in the regulatory crosshairs, and is currently under review by the European Commission.
Furthermore, under the Cross-Border Distribution Directive, any subscription made within 18 months of pre-marketing activity will be considered the result of such pre-marketing (for which a marketing filing must be made), which means promoters of such funds will not be able to rely on reverse solicitation for this period of 18 months.
Reliance upon national private placement regimes?
The extent to which third country managers have been able to rely on national private placement regimes under Article 42 of AIFMD varies between member states, but it has been a useful tool for accessing capital in certain markets (notably the UK, when it was a member state).
The future for national private placement regimes is uncertain in the wake of the Cross-Border Distribution Directive, since it includes a recital that states that national rules cannot in any way disadvantage EU AIFMs vis-à-vis non-EU AIFMs.
Reason to be Cheerful
While the challenges in accessing EU markets for UK managers are complicated by a no-deal Brexit outcome, they are by no means insurmountable, and we already work with managers in other third countries to help them to achieve successful outcomes. Service provider choice is critical to this process. And whilst the pre-marketing disclosure requirements under the Cross-Border Distribution Directive create an additional challenge for third country managers, its other provisions will facilitate distribution of UCITS and AIFs within the EU.
1. Please note that since the UK has now left the EU, we are no longer using the term EU27 to describe the EU ex UK.