On 29 March 2017, the United Kingdom gave the European Union two years' notice of its intention to leave the EU. However, as the world knows, that is not how events unfolded. Instead, the UK requested an extension to its notice period and, at the time of writing, remains a full member of the EU, with a revised notional exit date of 31 October 2019. That date, though, is far from certain: the exit could happen sooner, if the terms of withdrawal are agreed before the end of October; or it could be postponed again; or even cancelled altogether, if advocates for a second referendum ultimately win the day. But, for the moment, firms are focused on the end of October as the most likely date for Brexit—and they must be ready for that to be a disorderly (“no-deal”) Brexit.
All sides are hoping that this extra time will enable a “no-deal” outcome to be avoided and a Withdrawal Agreement to be signed that includes a “transitional period” lasting until at least December 2020. If so, it should be (more or less) business as usual until then for UK-based firms. But if there is no deal, and no further extension, UK-based firms must be ready to lose access to the EU’s single market this Halloween.
Meanwhile, the EU continues to quietly prepare for the day when the UK becomes a “third-country” (EU-speak for “not one of us”)—whenever that might happen. The final shape of the UK’s future relationship with the EU is as uncertain as when it will happen but, at the moment—at least so far as financial services is concerned—the UK is on course to rely on the EU’s partial and unsatisfactory “equivalence” rules to establish the terms of its access to EU-based investors. That is the path the UK government opted for in the non-binding Political Declaration that sits alongside the draft Withdrawal Agreement, and it has been the working assumption of law-makers and regulators ever since. Not surprisingly, that assumption has had an effect on the regulations relating to third-country access that have been in process.
Most obviously for the private funds sector, the assumption that the UK will one day be a third-country has scuppered any immediate hopes of the EU activating the “third-country passport” ordained by the Alternative Investment Fund Managers Directive (AIFMD). That would have given non-EU firms full access to the single market in exchange for non-EU managers agreeing to full compliance with AIFMD rules (including being supervised by an EU regulator). But the third-country passport is now even more political than it once was: giving UK private fund managers full, passported access to professional investors in the EU would be hard to push through the EU’s legislative process right now. Furthermore, forthcoming changes to the rules on fund cross-border marketing applicable to EU managers could have a negative, knock-on effect for non-EU (including UK) managers (as we recently reported here). So access to the EU market will certainly get tougher.
Many UK-based firms also need to consider the right of access for third-country firms contemplated by the EU’s Markets in Financial Instruments Directive (MiFID), which covers placement agents and some private equity firms that operate in the UK as “adviser-arrangers”—including many established by U.S. sponsors. It is somewhat unclear if and under what circumstances the marketing of funds is a regulated MIFID activity in the EU. The question has not been given much attention in the past, as UK firms had the required license in the UK and with that a passport to undertake MIFID activities in the EU. By losing that passport, these firms now face a fair amount of legal uncertainty. The third-country passport written into the MiFID rule book could help those firms when they lose the EU passport currently available to UK firms, even though this right of access for non-EU firms has also not yet been activated by the European Commission. But the rules for that passport, when it comes, are also being tightened.
In what seems to be a response to Brexit, provisions added to the revised EU prudential rules for investment firms (published earlier this year) will require the European Commission, when it considers whether to make a positive equivalence decision for a given country, to take into account the risks posed by the services and activities that firms from that third country could carry out in the EU. When the services and activities performed by third-country firms are likely to be of “systemic importance for the EU”, that country’s regulatory regime can only be considered equivalent after a “detailed and granular” assessment. In addition, the Commission may attach specific conditions to an equivalence decision to ensure that ESMA (the pan-EU regulator) and its national counterparts “have the necessary tools to prevent regulatory arbitrage and monitor the activities of third-country investment firms”. There will also be an annual reporting requirement on the scale and scope of services provided in the EU, the geographical distribution of the firm’s clients and investor protection arrangements. There are also proposals to tighten the reverse solicitation exemption.
Given the scale of access potentially required by UK firms to EU professional investors, the requirements imposed on firms accessing any future MiFID third-country passport have been significantly extended beyond the original model of a one-off registration with ESMA. Furthermore, whether the EU grants equivalence will be both a political and a technical exercise, depending in part of the state of relations between the UK and the EU at the time. Even if the UK follows EU rules, there is no guarantee that equivalence status will be granted and, even if it is, it may come with conditions or time limits.
So although there is good reason to hope that a close long-term relationship between the UK and the EU can ultimately be achieved, it remains sensible to plan for a less-positive outcome—especially since the ultimate resolution of these questions may be some years away, and with the potential for significant disruption in the meantime.
The Private Equity Report Spring, 2019, Vol 19, No 1