MiFID review - Key issues for non-EU firms

December 2011

Contacts

Introduction

The Markets in Financial Instruments Directive (MiFID) is one of the cornerstones of EU financial services law and has been in force since November 2007. Adopted in accordance with the so called EU Lamfalussy process it consists of a Framework Directive (Directive 2004/39/EC and hereafter called the Framework Directive) and two implementing measures, an implementing Directive (Directive 2006/73/EC) and an implementing Regulation (Regulation No 1287/2006).

MiFID applies to the EU and EEA member states which are collectively referred to as the “EU” in this briefing. There are currently 27 EU member states: Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden and the United Kingdom. The three EEA member states are: Iceland, Norway and Liechtenstein.

Non-EU firms under MiFID

At the moment access of non-EU investment firms (hereafter simply referred to as non-EU firms) to EU markets is not harmonised under MiFID. Instead it is left to the discretion of EU state regulators, subject to their general obligations under EU law and relevant international obligations, and provided that national provisions do not result in more favourable treatment than that given to EU investment firms. The practical reality of this is that non-EU firms are subject to an EU regulatory regime that is fragmented.

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Reasons for change

In December 2010, the European Commission (the Commission) published a consultation paper proposing certain changes to the Framework Directive. The Commission’s reasoning behind the consultation was that the financial crisis and market developments had demonstrated weaknesses in some of the underlying principles of MiFID and highlighted areas that needed reinforcement or revision.

Among the Commission’s proposed changes was the development of a harmonised and workable EU regulatory regime for the access of non-EU firms to EU financial markets. To achieve this, the Commission proposed the introduction of the principle of exemptive relief for non-EU firms based in jurisdictions with equivalent regulatory regimes. The Commission’s consultation closed on 2 February 2011.

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UK response to the consultation

In its joint response to the consultation the UK Financial Services Authority and the UK Treasury (together the UK authorities) expressed strong reservations about the Commission’s proposals to introduce the principle of exemptive relief for equivalent non-EU jurisdictions. The UK authorities believed that the proposal had the potential to undermine both the principle of free movement of capital and the ability of EU firms to do international business. In particular they stated:

We fear that such an approach would cause significant practical problems as well as potentially damaging relationships with other jurisdictions at a time when increased global cooperation is vital. At all times in developing this legislation we should bear in mind that protectionist attempts to close down our borders or balkanize markets by currency or geography will do huge damage to European growth.

As an alternative the UK authorities expressed support for exploring other options for achieving the Commission’s objectives. For example, they suggested that it might be worth considering making more explicit in the Framework Directive the point that existing EU state regulatory regimes needed to ensure that non-EU firms were treated no more favourably by EU states than EU investment firms. They also noted that recital 28 of the Framework Directive was less clear on this point than its predecessor Directive, the Investment Services Directive.

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The Commission’s proposals

On 20 October 2011, the Commission published legislative proposals amending the Framework Directive. The proposed legislation was in two parts comprising a draft recast Framework Directive (the recast Directive) and a draft new Regulation (the new Regulation).

The recast Directive and the new Regulation both include requirements that would fundamentally change the current position for non-EU firms doing business in the EU. These provisions broadly follow the changes the Commission proposed in its previous consultation. This note summarises the Commission’s proposals, and analyses their potential impact on non-EU firms.

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Rationale

In line with the Commission’s consultation the stated aim of the proposed regime is to address the current regulatory fragmentation concerning non-EU firms and to ensure certainty and uniform treatment in the EU. In addition, it has two key consequences:

  • First, it extends the regulatory oversight of EU state regulators to non-EU firms who, in turn, are required to subscribe to key MiFID operating and investor protection conditions before being granted entry to the EU market.
  • Second, it enhances the EU’s extra-territorial regulatory reach with both the Commission and the European Securities and Markets Authority (ESMA) playing a key role in the authorisation process.

The equivalence tests, which are one of the requirements that must be satisfied (see further below), in particular, may present a significant barrier to non-EU firms wishing to do business in the EU. To be assessed as equivalent, the non- EU firm’s home state regulator would have to impose equivalent requirements in numerous areas (including in relation to authorisation, ongoing supervision and enforcement, regulatory capital, personal account dealing, conflicts of interest, business continuity, outsourcing, record keeping and market conduct).

That said, the reward for any non-EU firms that are able to meet the requirements is an EU passport to provide investment services on a crossborder basis into other EU states. In the UK, at least, we have seen some reluctance on the FSA’s part to authorise branches of non-EU firms: the proposals may change this, and offer an alternative route to establishing an EU subsidiary and full MiFID compliance.

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Some basic MiFID concepts

A number of concepts in MiFID may be new to non-EU firms. In this section we briefly describe the investment services and activities that fall under MiFID and its client categorisation regime. Understanding these key concepts will give non-EU firms a better understanding of the Commission’s proposals.

The investment services and activities that require authorisation under MiFID are listed in Annex 1 of the Framework Directive. This comprises:

  • Reception and transmission of orders in relation to one or more financial instruments.
  • Execution of orders on behalf of clients.
  • Dealing on own account.
  • Portfolio management.
  • Investment advice.
  • Underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis.
  • Placing of financial instruments without a firm commitment basis.
  • Operation of multilateral trading facilities.
  • The recast Directive seeks to add two further investment services and activities to this list being:
  • Safekeeping and administration of financial instruments for the account of clients, including custodianship and related services such as cash/ collateral management.
  • Operation of organised trading facilities.

Financial instruments are those instruments defined in Section C of the Framework Directive. This includes transferable securities, units in collective investment schemes, options, futures, swaps, forwards and certain other derivative contracts that can be physically settled. The recast Directive seeks to extend the list of financial instruments by including emission allowances.

MiFID recognises that investors have different levels of knowledge, skill and expertise and that regulatory requirements should reflect this. The Framework Directive adopts two main categories of client: retail and professional. There is a separate and distinct third category for a limited range of business: eligible counterparty. The recast Directive does not significantly amend MiFID’s client classification regime. A list of per se professional clients (ie, entities that are automatically treated as professional clients) is set out in Annex II of the Framework Directive. The definition of professional client includes all of the entities that fall within the eligible counterparty category plus a handful of others (such as institutional investors whose main activity is to invest in financial instruments). Per se eligible counterparties include investment firms, credit institutions, insurance companies, undertakings for the collective investment of transferable securities (UCITS), pension funds and national governments. Retail clients are those clients who are not considered to be either professional clients or eligible counterparties.

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EU retail clients

Articles 41 to 46 of the recast Directive set out high level provisions where non-EU firms wish to provide MiFID-scope investment services and/or activities to retail clients in the EU. The key requirement is that the provision of such services to EU retail clients will necessitate the establishment of a branch in an EU state and the branch’s EU state regulator must authorise that branch before any services are provided. The exception to this is where the services are provided at the client’s own exclusive initiative (see further below).

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Equivalence decision

However, a non-EU firm cannot submit an application for authorisation until the Commission has adopted a decision affirming the equivalence of that non-EU firm’s home state regulatory regime (Article 41(4) of the recast Directive). In order to adopt such a decision Article 41(3) of the recast Directive provides that the Commission must be satisfied that the non-EU firm’s home state imposes:

  • Legal and supervisory arrangements that are equivalent to those under the recast Directive, the new Regulation and the Capital Adequacy Directive.
  • An equivalent prudential framework.

The Commission will only deem a non-EU state to have an equivalent prudential framework where non-EU firms providing services in that jurisdiction are subject to:

  • Authorisation, and effective supervision and enforcement, on an ongoing basis.
  • Sufficient capital requirements and appropriate requirements applicable to shareholders and members of their management body.
  • Adequate organisational requirements in the area of internal control functions.
  • A regime which ensures market transparency and integrity by preventing market abuse in the form of insider dealing and market manipulation.
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Additional requirements

The Commission’s equivalence decision is not the only hurdle for non-EU firms. Certain requirements concerning the non-EU firm, the branch and the non-EU state itself must also be met before authorisation is granted. These requirements are set out in Article 41(b) to (g) of the recast Directive and cover:

Non-EU firm-specific requirements

  • The provision of services for which the non-EU firm seeks authorisation is regulated by its home state regulator and that it is properly authorised (Article 41(1)(b) of the recast Directive).
  • The non-EU firm has requested membership of an investor-compensation scheme authorised or recognised in accordance with the Investor- Compensation Schemes Directive (Article 41(1)(g) of the recast Directive).

Branch-specific requirements

  • There is sufficient initial capital at the free disposal of the branch (Article 41(1)(d) of the recast Directive).
  • The person(s) responsible for the management of the branch are appointed and comply with the obligations placed on management bodies of EU investment firms under Article 9(1) of the recast Directive (Article 41 (1)(e) of the recast Directive).

Non-EU state-specific requirements

  • The home state of the non-EU firm is not listed as a Non-Cooperative Country and Territory by the Financial Action Task Force on anti-money laundering and terrorist financing (Article 41(1)(b) of the recast Directive).
  • There are cooperation arrangements in place between the regulator of the EU state where the branch is to be registered and the home state regulator of the non-EU firm which, inter alia, govern the exchange of information for the purpose of preserving the integrity of the market and protecting investors (Article 41(1)(c) of the recast Directive).
  • The home state regulator of the non-EU firm has signed an agreement with the regulator of the EU state where the branch is to be established, which complies with the standards set down in Article 26 of the OECD Model Tax Convention and ensures an effective exchange of information on tax matters, including, any multilateral tax agreements (Article 41(1)(f) of the recast Directive).

For a further discussion concerning the obligations placed on management bodies of investment firms under Article 9(1) of the recast Directive please refer to our MiFID review briefing note on authorisation and organisation requirements which can be found on our Pegasus web pages.

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Application for authorisation

Article 42 of the recast Directive sets out the information that the non-EU firm must provide to the regulator of the EU state where the branch is to be established. Such information relates to the non-EU firm, the intended branch and the non-EU state itself:

Non-EU firm-specific requirements

  • All relevant details of the non-EU firm (name, legal form, registered office and address, members of the management body, relevant shareholders) and a programme of operations setting out, inter alia, the services contemplated (Article 42(b) of the recast Directive).

Branch-specific information

  • The name(s) of those who will manage the branch as well as documentary evidence of their compliance with the obligations placed on management bodies of EU investment firms under Article 9(1) of the recast Directive (Article 42(c) of the recast Directive).
  • Information about the initial capital at the free disposal of the branch (Article 42(d) of the recast Directive).
  • The organisational structure of the branch, including a description of any outsourcing to third parties of essential operating functions (Article 42(b) of the recast Directive).

Non-EU state-specific requirements

  • The name(s) of the non-EU state regulator(s) and details of their respective areas of competence (Article 42(a) of the recast Directive).
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Granting of authorisation

Article 43 of the recast Directive provides that the non-EU firm will be informed by the EU state regulator, within six months of submitting a complete application, as to whether or not their authorisation has been granted.

Authorisation to establish a branch will only be granted to the requesting non-EU firm if the EU state regulator is satisfied that the conditions under Article 41 of the recast Directive are fulfilled and that the branch will be able to comply with the wide range of relevant obligations set down in both the recast Directive and new Regulation. In particular the branch must be able to comply with the obligations set down in Articles 16 (organisational requirements), 17 (algorithmic trading), 23 (conflicts of interest), 24 (general investor protection principles and information to clients), 25 (assessment of suitability and appropriateness and reporting to clients), 27 (obligation to execute orders on terms most favourable to the client), 28(1) (client order handling) and 30 (transactions executed with eligible counterparties) of the recast Directive and Articles 13 to 23 (transparency for investment firms trading over-the-counter including systemic internalisers and transaction reporting) of the new Regulation (Article 43(1)(b) and 43(2))).

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Harmonisation

Article 43(2) of the recast Directive makes it clear that EU state regulators cannot impose any additional requirements on the organisation and operation of the branch in respect of the matters covered by the recast Directive.

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Providing investment services in other EU states

A non-EU firm which has been granted authorisation in accordance with Article 43 of the recast Directive, may apply to passport the provision of its authorised services into other EU states, without having to establish a further branch. It must, however, provide the EU state regulator in which it has the branch with the following information:

The other EU states in which it intends to operate (Article 44(1)(a) of the recast Directive).

A programme of operations stating the particular investment services or activities as well as ancillary services which it intends to perform in those other EU states (Article 44(1)(b) of the recast Directive).

The EU state regulator in which the non-EU firm’s branch is established shall, within one month of receiving this information, forward it to the other EU state regulators. The non-EU firm may then start to provide services in the other EU states. It is important to note that the non-EU firm will remain subject to the supervision of the EU state regulator in which the branch is established.

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Registration

Each EU state regulator will maintain a register of the non-EU firms they have authorised. EU state regulators will also notify ESMA of every authorisation they make. ESMA in turn will establish a list of all non-EU firms that are authorised to provide services to EU retail clients. That list will be publicly available on ESMA’s website.

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Key role for ESMA

The recast Directive sees ESMA playing a key role in the authorisation process of non-EU firms through the provision of technical standards that EU state regulators will have to follow. Under Article 44(2) of the recast Directive, ESMA will develop, and submit to the Commission for adoption and implementation, draft technical standards, procedures and standard form templates that will determine the minimum or detailed content of:

  • The cooperation arrangements required to be in place between the EU state and the non-EU state regulators, under Article 41(1)(c) of the recast Directive, to ensure that the EU state regulator authorising the branch is able to exercise its supervisory powers under MiFID.
  • The programme of operations setting out the contemplated investment services to be provided by the branch.
  • The information relating to the management of the branch, as required under Article 42(c) of the recast Directive.
  • The information relating to the initial capital at the free disposal of the branch, as required under Article 42(d) of the recast Directive.

At present the recast Directive does not specify when ESMA will deliver such draft technical standards to the Commission.

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Withdrawal of authorisation

Non-EU firms should note that obtaining authorisation is not an end to the EU supervisory regime. Article 46 of the recast Directive provides that a non-EU firm’s authorisation may be withdrawn by the EU state regulator where the branch is established if the non-EU firm:

Does not use the authorisation within 12 months, expressly renounces it or does not perform investment services for the preceding six months, unless the EU state regulator has permitted a lapse of the authorisation in such cases (Article 46(a) of the recast Directive).

  • Has obtained its authorisation through the making of false statements or any other irregular means (Article 46(b) of the recast Directive).
  • No longer meets the conditions under which it was authorised (Article 46(c) of the recast Directive).
  • Has seriously infringed the provisions adopted pursuant to MiFID which govern the operating conditions for investment firms and applicable to non-EU firms (Article 46(d) of the recast Directive).
  • Falls within any of the cases where national law requires withdrawal (Article 46(e) of the recast Directive).

ESMA will be notified of all withdrawals of authorisation. Where a non-EU firm has had its authorisation withdrawn ESMA will publish that fact for a period of five years on the list made under Article 45 of the recast Directive.

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ECPs

Recital 35 of the new Regulation states that the provision of services by a non-EU firm without the establishment of a branch should be limited to eligible counterparties (ECPs). Articles 36 to 39 of the new Regulation then set out high level requirements, which include an obligation to register with ESMA. This is one of the most noticeable points concerning the new requirements in that non-EU firms have to register directly with ESMA in these instances rather than apply for authorisation with an EU state regulator.

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Services

In the context of EU retail clients Article 41 of the recast Directive refers to the non-EU firm providing MiFID-scope services and/or activities. When dealing with ECPs Article 36 of the new Regulation adopts a slightly more complex approach. Article 36(1) states that the services to be provided to ECPs by a non-EU firm without the establishment of a branch will be those that are listed in Article 30 of the recast Directive. Article 30 of the recast Directive discusses a limited range of business executed with ECPs covering only the execution of orders on behalf of clients, dealing on own account and the reception and transmission of orders in relation to one or more financial instruments.

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Equivalence decision

Like the provision of services to EU retail clients the key requirement is for the Commission to adopt an equivalence decision regarding the regulatory regime of the non-EU firm’s home state. In order to adopt such a decision Article 37 of the new Regulation sets out the same requirements as Article 41(3) of the recast Directive in that the Commission must be satisfied that the non-EU firm’s home state imposes:

  • Legal and supervisory arrangements that are equivalent to those under the recast Directive, the new Regulation and the Capital Adequacy Directive.
  • An equivalent prudential framework.

The assessment of an equivalent prudential framework covers the same ground as the recast Directive but with a further requirement that the non-EU firm must be subject in its non-EU home state to appropriate conduct of business rules. This additional requirement is unsurprising because, even though limited conduct of business rules apply to ECP business, the branch regime for EU retail clients requires the non-EU firm to be subject to EU state conduct of business rules (see the discussion concerning granting authorisation above). Adding this requirement ensures a harmonised conduct of business regime where no branches are involved.

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Additional requirements

Like the branch authorisation requirements the Commission’s equivalence decision is not the only hurdle for non-EU firms. Certain requirements concerning the non-EU firm and the non-EU firm’s home state must also be met before registration. These requirements are set out in Article 36(2) and 37(2) of the new Regulation and cover:

Non-EU firm-specific requirements

  • The non-EU firm must be authorised in its non-EU home state to provide the services to be provided in the EU.
  • The non-EU firm must be subject to effective supervision and enforcement ensuring full compliance with the regulatory requirements applicable in its non-EU home state.

Non-EU state-specific requirements

  • ESMA must have in place with the non-EU firm’s home state regulator cooperation arrangements. Such arrangements will specify at least how information will be exchanged between the regulators, the procedures concerning the coordination of supervisory activities including on-site inspections and the mechanism for prompt notification to ESMA where the non-EU state regulator deems the non-EU firm to be in breach of its conditions for authorisation or other legislation to which it is obliged to adhere.
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Application for authorisation

Once the Commission has adopted an equivalence decision a non-EU firm may apply to ESMA for registration (Article 36(3) of the new Regulation). The non-EU firm must provide ESMA with all information deemed necessary for its registration. Article 36(6) of the new Regulation provides that ESMA will produce regulatory technical standards that will specify the information that the non-EU firm will need to provide.

Within 30 days of the receipt of the application ESMA will assess whether the application is complete. If the application is not complete then ESMA will set the non-EU firm a deadline in which it has to provide the additional information. When a completed application is submitted ESMA then has a further 180 working days to inform the non-EU firm whether its application has been successful. ESMA must inform the non-EU firm in writing giving a fully reasoned explanation for its decision.

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Prior notification to clients

It is also worth noting the requirement in Article 36(4) of the new Regulation. This provides that non-EU firms providing services to ECPs in accordance with the new Regulation must inform EU clients before providing any services that they are not allowed to provide services other than to ECPs and that they are not subject to supervision in the EU. Non-EU firms are also required to indicate the name and address of their non-EU home state regulator. There is no equivalent provision in the recast Directive but this is unsurprising given that branches of non-EU firms will be able to provide services to EU retail clients and will be effectively subject to EU supervision.

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Registration

Should the application be successful ESMA will register the non-EU firm. A register of successful applicants will be publicly accessible on ESMA’s website. The register will also list the services that the non-EU firm may provide and the reference of its non-EU home state regulator.

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Withdrawal of registration

Article 39 of the new Regulation allows ESMA to withdraw a non-EU firm’s registration if it has well founded reasons based on documented evidence to believe that the non-EU firm has either:

  • Acted in a manner which is clearly prejudicial to the interests of investors or the orderly functioning of markets.
  • Has seriously infringed the provisions applicable to it in its non-EU home state and on the basis of which the Commission has adopted an equivalence decision.

However, ESMA will only take such action if two conditions are satisfied:

  • It has referred the matter to the non-EU firm’s home state regulator and that regulator has not taken the appropriate measures needed to protect investors and the proper functioning of EU markets or has failed to demonstrate that the non-EU firm complies with the requirements applicable to it in the non-EU home state.
  • It has informed the non-EU firm’s home state regulator of its intention to withdraw registration at least 30 days before withdrawal.
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The carve out

Both the recast Directive and the new Regulation refer to a caveat to the requirements for non-EU firms. Both state that their respective provisions should not affect the possibility for persons established in the EU to receive investment services by a non-EU firm at their own exclusive initiative. When a non-EU firm provides investment services at the own exclusive initiative of a person established in the EU the services are not deemed to be provided in the territory of the EU. However, where the non-EU firm solicits clients or potential clients in the EU or advertises its investment services in the EU then the services will not be deemed to be provided at the own exclusive initiative of the client.

Obviously non-EU firms will find it very difficult to rely on this exclusion and its exact scope particularly in the internet age is unclear. For example if a non- EU firm decides to do some generic internet advertising which is available in the EU will it be unable to rely upon the exemption because of the prohibition on advertising?

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Other third country relevancies

Non-EU firms may be subject to the mandatory on-platform trading obligation set out in Articles 24 to 27 of the new Regulation. This requires that certain derivative transactions must be concluded on one of certain trading platforms and implements one of the G20 commitments.

The obligation applies to the EU financial counterparties and non-financial counterparties that are within the scope of the proposed Regulation on over-the-counter derivatives, central counterparties and trade repositories (otherwise known as EMIR). As in EMIR, this obligation applies not only when they conclude transactions with one another, but also when they enter into transactions with non-EU entities that would be subject to the clearing obligation in EMIR if they were established in the EU. It may also apply to non-EU entities that would be subject to such clearing obligation if they were established in the EU, which enter into derivatives that are subject to the trading obligation, provided the contract has a direct, substantial and foreseeable effect within the EU or where such obligation is necessary or appropriate to prevent the evasion of any provision of the new Regulation.

The trading platforms on which derivatives subject to this obligation may be traded include, alongside EU regulated markets, multilateral trading facilities and organised trading facilities, certain non-EU trading venues. They will only qualify if the Commission has adopted an equivalence decision and the non-EU state reciprocates in recognising trading venues that are authorised under the recast Directive for the purposes of its own mandatory on-platform trading obligation.

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The regime for professional clients

One of the most intriguing aspects of the recast Directive and the new Regulation is that neither covers the position concerning the provision of investment services by a non-EU firm to EU professional clients. It is not clear at the moment whether this has been intentional or not. This is something that non-EU firms will need to keep an eye on.

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Timing

It should be remembered that the Commission’s legislative proposals are in draft form and are currently being debated in both the European Parliament and the Council of the European Union under the so called co-decision procedure (also known as the ordinary legislative procedure). This legislative process is based on the principle of parity and means that neither institution may adopt the legislation without the other’s assent. Given the time taken for political agreement on other key pieces of EU legislation (for example the Alternative Investment Fund Managers Directive) we do not expect the legislation to be finalised until sometime in 2012/13. Once finalised, the legislation will take another two years to come into effect.

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Transitional provisions

Article 99 of the recast Directive states that existing non-EU firms will be able to continue to provide services and activities in accordance with EU national regimes until four years after the recast Directive’s entry into force. The Commission is also empowered under this Article to extend the transitional period taking into account any equivalence decisions that have already been made and expected developments in the regulatory and supervisory framework of non-EU states.

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Overseas persons exclusion under the RAO

In the UK the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (the RAO) contains a number of general exclusions which can take firms outside the scope of regulation and avoid the need for authorisation by the UK Financial Services Authority. A particular exclusion that many non-EU firms rely upon is the so called overseas persons exclusion contained in Article 72 of the RAO. Generally speaking our current view is that this exclusion will disappear in favour of the mutual recognition regime set out in the Commission’s legislative proposals. In light of this many third country firms that rely on this exemption will need to review their regulatory analysis.

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Pegasus

Firms can stay on top of the MiFID review proposals by logging onto our online technical resources pages called “Pegasus”. In particular we have a dedicated page on Pegasus for third country firms.

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