ESMA Sets the Ground Rules for the Post-Brexit Gold Rush – The Sequel

ESMA’s recently published Brexit relocation opinions may foreshadow the focus areas of the upcoming UCITS and AIFMD reviews in 2018.

 Last month, European Securities Market Authority (ESMA) published nine principles for firms relocating from the UK as a result of Brexit. With Brexit negotiations now in full swing, ESMA has expanded upon its original opinion by issuing further guidance for investment firms, investment management, and secondary markets.

The opinion calls on regulators to prevent fast-tracking, creation of letter-box entities, and circumvention of regulation by UK firms wishing to relocate and retain the benefits of EU passporting. ESMA wants to calm all suggestions of regulatory arbitrage to ensure a level playing field for the EU locations vying to become the next European financial center.

The opinion addresses authorization, governance, due diligence, white label businesses, and oversight of appointed delegates. The investment management opinion has generated the most industry debate, particularly around the proposed imposition of third-country (those situated in non-EU countries) delegation provisions to UCITS.

Portfolio Management Delegation to Third Countries

In its opinion, ESMA sets out thorough requirements for due diligence when selecting delegates, as well as ongoing assessments of such delegation arrangements. Third-country delegates will be given special consideration and if portfolio management is delegated to a third-country, the remuneration requirements should adhere to ESMA’s existing guidelines in Alternative Investment Fund Managers Directive (AIFMD) and UCITS. ESMA also insists there are “objective reasons” for such delegation of investment management to a third-country and seek to ensure such delegation does not circumvent EU substance requirements.

The reason ESMA specifically hones in on third-country asset managers who perform portfolio management on behalf of a UCITS is that the EU has a strong desire to prevent UK (or any non-EU) asset managers creating EU-based letter-box entities who then delegate the majority of activity back to their home country. The EU’s position is that any firm who benefits from passporting should have appropriate “substance” within the EU in order for ESMA to properly regulate those firms.

No Third-Country Provisions Under UCITS

As discussed last year, the UCITS framework does not have third-country provisions. National regulators have discretion on which activities may or may not be delegated to a third-country. In practice, portfolio management delegation by UCITS is common in order to leverage the best investment expertise regardless of location. Altering the existing UCITS regime to amend delegation provisions would require a redraft of UCITS regulations by ESMA and further approval by the European Commission and Parliament.

Next year, as part of its Mid-Term Review of the Capital Markets Union, ESMA will review the UCITS and AIFMD frameworks. It is very likely the requirements laid out in these Brexit relocation opinions will form part of that review. This would further increase the possibility of the creation of a third-country regime for UCITS. ESMA is focused on convergence and harmonization within their regulatory agenda, and it’s likely they will look to enhance and align rules on all third-country equivalence provisions across all significant EU regulations, including AIFMD, European Market Infrastructure Regulation (EMIR), Markets in Financial Instruments Directive (MiFID 2), and UCITS. If so, UCITS can expect another tweak in its continued evolution. However, since UCITS is considered the gold standard of fund regimes, there will be push back from the industry on concept of establishment of a UCITS third-country regime as they will want to retain unfettered access to the best investment talent.

A Non-Binding Opinion

Many in the industry believe ESMA has gone above its remit to impose requirements over existing UCITS, MiFID, and AIFMD rules. However, it’s important to remember that ESMA’s opinion is not binding, and national regulators can choose to apply the recommendations at their discretion. In major EU fund domiciles, many of the delegation and governance issues contained in the opinion have already been addressed. Luxembourg’s regulator, the Commission de Surveillance du Secteur Financier, has already issued a communiqué stating the opinion’s principles “are in line with the CSSF’s practice.” Ireland expects to find itself in the same position having addressed many of these issues last year within its CP86 debate.

Waiting Game

While the opinions address UK investment managers, UCITS, and AIFMs relocating to the EU, it is relevant to all EU firms since regulators could extend the requirements to existing firms. For now, asset managers should reconcile their existing structures against ESMA’s principles and await the actions of the national regulators reaction to the opinions. The review of the UCITS and AIFMD frameworks next year will provide a much clearer view on ESMA’s desire to retain or constrain UCITS access to third country portfolio management capabilities.