With financial services firms still coming to grips with the UK’s referendum result to leave the EU there continues to be a sense of a journey into the unknown. In this latest financial services briefing we take a look at some of the key themes that the industry is considering.
1 | The latest on the Article 50 notification
A debate over when and how the UK would notify the European Council of the UK’s intention to withdraw from the EU under Article 50 of the Treaty on European Union began almost as soon as the referendum result was announced. Since the referendum there have been calls for Parliament to approve triggering the notification rather than the Government using Royal prerogative powers.
There have also been judicial review claims challenging the Government’s ability to trigger Article 50. The Divisional Court has ordered the various claims to be joined together and has set a provisional hearing date before the Lord Chief Justice for 15 October 2016, with a possible “leapfrog” procedure straight to the Supreme Court after that, with a view to it being heard in December 2016.
The timing of the Article 50 notification is entirely in the hands of the UK and there has been much comment from EU politicians that informal negotiations cannot take place. Recently the press reported that the Foreign Secretary, Boris Johnson, has said that the UK will “probably” begin formal negotiations to leave the EU in early 2017. Prime Minister Theresa May has stated during the Conservative Party Conference that the notification would be made by the end of March 2017.
2 | What have financial services firms been doing?
The financial services industry has embarked on a fairly extensive exercise with firms looking at the range of business activities they perform and the extent to which they use available passporting arrangements. Unfortunately this is not a straight-forward exercise as many firms have to re-think their businesses in terms of regulatory permissions and the process of working out which activities, transactions and relationships would not exist without some form of passporting arrangement can be extremely complex.
For the bigger players that already have subsidiaries in other parts of the EU access to the Single Market may be less of an issue. However, the question that these firms face is to what extent they need to transfer activities and services from their UK operations and whether the relevant EU subsidiary has the necessary resources and permissions in place. In many cases this has ultimately led to firms topping up their EU subsidiaries’ permissions and developing resource capability.
Where a firm is considering establishing an EU subsidiary for the first time some comfort may be taken that across Europe regulatory structures are similar but if a substantial amount of business is to be moved the attitude of the local regulator will be an important factor. In addition, establishing a subsidiary in another Member State takes time and can be a costly exercise.
3 | Passporting
Some in the market have been considering the issue of when and where a service or activity is carried on under the Single Market directives. Recently the FCA released some interesting data as regards the use of the passport noting in particular that out of a total of 359,953 passports, 23,532 were inbound (into the UK from another EU or EEA state) and 336,421 were outbound (from the UK to another EU or EEA state).
In the banking sector the European Commission’s 1997 Interpretative Communication, Freedom to provide services and the interests of the general good in the Second Banking Directive (Interpretative Communication), provides guidance on the so-called ‘characteristic performance’ test which the FCA and PRA use when considering whether a credit institution or MiFID investment firm should make prior notification for services business. Whilst the Interpretative Communication’s origins can be traced to back to the Banking Consolidation Directive the FCA and PRA have confirmed that it may also be applied to MiFID on the basis that chapter II of title II of MiFID (operating conditions for investment firms) applies to the investment services and activities of firms operating under the CRD IV (which ultimately replaced the Banking Consolidation Directive). It is worth noting that the Interpretative Communication is guidance and does not necessarily represent the views of Member States nor does it impose any obligation on them. In some Member States a solicitation test is used instead of the characteristic performance test.
Possible further guidance on the UK’s interpretation of the characteristic performance test can be found in the Securities and Investment Board's (SIB) (one of the predecessor organisations to the Financial Services Authority) draft guidance release of March 1989 (Carrying on investment business in the United Kingdom). In this release the SIB considered the interpretation of when an individual engages in one or more activities which fall within the activities set out in the Financial Services Act 1986 (the predecessor legislation to the Financial Services and Markets Act 2000 (FSMA)).
4 | Overseas persons’ exclusion
Importantly the overseas persons’ exclusion found in article 72 of the FSMA (Regulated Activities) Order 2001 is not replicated across the EU. It is too soon to say whether or not the exclusion will remain in its current form or whether it will be changed or removed completely as part of the Brexit negotiations. However, an analysis of the exclusion is worthwhile when considering the impact of the removal of the passport for firms coming into the UK.
The exclusion for overseas persons applies to certain regulated activities such as: dealing as agent or principal; making arrangements for another person to buy, sell, subscribe for or underwrite particular investments; advising on investments; operating a multilateral trading facility; agreeing to carrying on certain activities including agreeing to manage investments; and certain activities in relation to home finance transactions.
The exclusion is usually available in the following two instances.
First, where the nature of the regulated activity requires the direct involvement of another person and that person is authorised or exempt (and acting within the scope of their exemption). For example, this may occur where:
- the person in the UK, with whom an overseas person deals, is an authorised person acting on behalf of a client; or
- where the arrangements the overseas person makes are for transactions to be entered into by an authorised person.
Second, where a particular regulated activity is carried on as a result of what is termed a ‘legitimate approach’. An approach by a person in the UK is a legitimate approach to an overseas person provided it has not been solicited by the overseas person in any way, or has been solicited in a way that does not contravene the restrictions on financial promotion in section 21 of the FSMA.
There are a number of exemptions to the financial promotion restrictions under section 21 of the FSMA. For example, those set out in articles 30 to 33 of the FSMA (Financial Promotion) Order 2005 relate to financial promotions sent into the UK by an overseas communicator who does not carry on certain regulated activities in the UK. These exemptions apply in addition to any other exemptions which may apply to any particular financial promotion by an overseas communicator.
Article 30 exempts any solicited real time financial promotion made by an overseas communicator from outside the UK in the course of, or for the purposes of, certain regulated activities which he/she carries on outside the UK. This allows an overseas communicator, for example, to respond to: (i) an unprompted telephone enquiry made by a person in the UK; or (ii) an enquiry which follows a financial promotion made by the overseas communicator and which was approved by an authorised person.
Article 31 exempts non-real time financial promotions made by an overseas communicator from outside the UK to ‘previously overseas customers’ subject to certain conditions. To satisfy this exemption, the communicator must be based overseas and must be communicating with a person who is, or was recently, a customer of his/her while that person too was overseas.
To make an unsolicited real time financial promotion, an overseas communicator may be able to rely on either article 32 or article 33. Article 32 provides an exemption for unsolicited real time financial promotions made by an overseas communicator to persons who were previously overseas and were a customer of his/her at that time. This is subject to certain conditions, including that, in broad terms, the customer would reasonably expect to be contacted about the subject matter of the financial promotion.
Article 33 broadly applies where the overseas communicator:
- has reasonable grounds to believe that the recipient is knowledgeable enough to understand the risks associated with the controlled activity to which the financial promotion relates;
- has informed the recipient that he will not gain the protections under the FSMA in respect of the activity or of the making of unsolicited real time financial promotions; and
- has informed the recipient whether he will lose the benefit of dispute resolution and compensation schemes.
The recipient must also have signified clearly that he/she accepts the position after having been given a proper opportunity to consider the information. There is no definition of a proper opportunity for this purpose. In the FSA’s (the predecessor of the FCA) opinion it was likely to require the recipient to have a reasonable time to reflect on the matter and, if appropriate, seek other advice. What is a reasonable time depended upon the circumstances of the recipient but it was unlikely that a time of less than 24 hours would be enough.
5 | How far does equivalence get us?
In one sense the application of equivalence is currently limited and may not be a complete solution for firms outside the EU. Whilst a number of important pieces of EU legislation contain equivalence provisions, some do not. For example, the CRD IV does not contain equivalence provisions meaning that classic corporate banking – deposit taking and lending to companies – is not covered. Also, there are no equivalence measures within the UCITS Directive which covers retail asset management.
For EU legislation that currently contains equivalence provisions (for example MiFID, AIFMD and EMIR) there is an argument that the UK will be equivalent as it continues to apply Single Market legislation. However, although an equivalence determination is a legal test the conclusion is fundamentally a political decision meaning that it cannot be taken for granted. However, even where the UK is determined to have equivalent status it would have to be cautious in its approach to new domestic legislation. Whilst equivalence is not about being identical but rather achieving the same outcome a determination may be removed at short notice should a new national legislative provision be introduced that is not matched on the EU side.
Some in the market have argued that ideally any determination of equivalence would be part of the final agreement made between the UK and EU. In addition, there may have to be some sort of agreement between the EU and UK not to diverge too radically from each other’s regulatory structure.
6 | MiFID II / MiFIR equivalence
The third country regime under MiFID II / MiFIR is not fully harmonised.
Harmonisation has been achieved for the cross-border provision of investment services and/or activities provided to per se professional clients and eligible counterparties (articles 46 to 49 MiFIR) but not to retail clients and opted-up professional clients (articles 39 to 43 MiFID II).
The MiFID II regime for retail clients and opted-up professional clients sets out detailed rules that are designed to harmonise the requirements with which the branch of a third country firm will have to comply in order to be authorised by the Member State in question. However, these detailed rules are optional and some Member States (including the UK) have decided to maintain their own national regime.
The regime in MiFIR deals with the position where a third country firm wishes to provide investment services and/or activities to eligible counterparties and per se professional clients on a purely cross-border basis. The key element in these provisions is that the third country firm must pre-register with the European Securities and Markets Authority (ESMA). ESMA will only register a third country firm where:
- the Commission (rather than ESMA) has adopted a decision that the prudential and business conduct requirements in the third country firm’s home jurisdiction have equivalent effect to MiFID II and CRD IV;
- the Commission’s decision also concludes that such third country has an effective and equivalent system for the recognition of investment firms authorised under the respective third country legal regime;
- the third country firm is authorised and effectively supervised in its home country in respect of the provision of the relevant services; and
- co-operation arrangements exist between ESMA and the third country firm’s home state competent authority which, among other things, relate to the exchange of information and co-ordination of supervisory activities.
The prudential and business conduct requirements in the third country firm’s home state may be considered to be equivalent where all of the following conditions are satisfied:
- firms providing investment services and activities in that third country are subject to authorisation and to effective supervision and enforcement on an ongoing basis;
- firms providing investment services and activities in that third country are subject to sufficient capital requirements and appropriate requirements applicable to shareholders and members of their management body;
- firms providing investment services and activities are subject to adequate organisational requirements in the area of internal control functions;
- firms providing investment services and activities are subject to appropriate conduct of business rules; and
- the requirements ensure market transparency and integrity by preventing market abuse in the form of insider dealing and market manipulation.
The recitals to MiFIR add further detail on equivalence. For example recital 41 mentions that:
- the Commission should initiate the equivalence assessment on its own initiative;
- when initiating equivalence assessments the Commission should be able to prioritise among third country jurisdictions taking into account the materiality of the equivalence finding to EU firms and clients, the existence of supervisory and cooperation agreements between the third country and Member States, the existence of an effective equivalent system for the recognition of investment firms authorised under foreign regimes as well as the interest and willingness of the third country to engage in the equivalence assessment process; and
- the equivalence assessment should be outcomes based and should assess to what extent the respective third country regulatory and supervisory regime achieves similar and adequate regulatory effects and to what extent it meets the same objectives of EU law.
Recital 44 adds that decisions determining third-country regulatory and supervisory frameworks as equivalent to the regulatory and supervisory framework of the EU should only be adopted if the legal and supervisory framework of the third country provides for an effective equivalent system for the recognition of investment firms authorised under foreign legal regimes in accordance with, amongst others, the general regulatory goals and standards set by the G20 in September 2009 of improving transparency in the derivatives markets, mitigating systemic risk and protecting against market abuse. Importantly the recital adds that such a system should be considered equivalent if it ensures that the substantial result of the applicable regulatory framework is similar to EU requirements and should be considered effective if those rules are being applied in a consistent manner.
A third country firm may only apply for ESMA registration once the Commission has made a positive equivalence decision. On receipt of a completed application ESMA has to grant or refuse registration within 180 working days.
Both MiFID II and MiFIR provide that a third country firm may provide investment services and/or activities on the exclusive initiative of a client, without requiring branch authorisation or ESMA registration. However, such exclusive initiative is likely to be interpreted strictly by the EU authorities.
7| Transitional period
The two year negotiation period provided by Article 50 (mentioned above) is a concern particularly in light of the quantum of change that needs to be negotiated. This concern has been exacerbated by comments from some EU officials that negotiations with the UK cannot begin until the UK has formally triggered the Article 50 notification. In light of this there have been numerous calls in the market for a transitional period of at least two years post exit. Obviously a transitional period would contribute to a period of certainty for firms although it is dependent on the UK and EU reaching agreement.
Transitional provisions are nothing new in EU financial services legislation. For example, article 160 of the CRD IV contains transitional provisions for capital buffers. Both MiFID II and MiFIR contain transitional provisions. In particular article 54 of MiFIR provides that third country firms shall be able to provide investment services and/or activities in Member States in accordance with national regimes until three years after the Commission has adopted an equivalence decision.
8 | Bonfire of regulation
Many in the market have argued that in the short term there should be no bonfire of regulation and that the UK Government should keep EU legislation effectively intact and turn directly applicable EU Regulation into domestic legislation. This, they argue, would provide for some certainty immediately after the UK’s exit and such a move would aid the UK’s push for equivalent status.
Notwithstanding the above much of EU regulation is taken from international commitments. The UK will continue to be a member of, and seek to implement the global standards that are set by, various international bodies including the Financial Stability Board, the G20 and the Basel Committee on Banking Supervision.
However, to retain equivalent status in the future the UK will need to carefully monitor how the EU takes the standards produced by these international bodies and translate it into specific regulation. How the UK can influence the EU process without having a seat at the table needs to be thought through very carefully.
9 | Exit model
There appears to be emerging thinking in the market that the UK needs a bespoke arrangement with the EU and that the existing possible alternatives like the Norwegian model are not feasible. However, it is far from clear as to what this arrangement would look like. Some have touted the idea of some sort of binding international arrangement that provides mutual rights of access.
10 | Impact of the EU referendum
On 26 September 2016, the CBI issued its latest financial services survey noting the impact of the EU referendum:
- 53 per cent of firms reported that the vote to leave the EU had a negative general impact on their organisation, compared with 12 per cent reporting a positive general impact, giving a balance of -41 per cent; and
- main source of concern was market volatility, with 71 per cent of firms pointing to negative impact and 8 per cent reporting a positive impact, giving a balance of -63 per cent.
Rain Newton-Smith, CBI Chief Economist, said:
“As firms get back into the swing of things after the summer, and continue to digest the implications of the EU Referendum, it’s good to see that demand in the financial services sector has held up.
“But the challenges facing the sector have not gone away - they’ve actually grown. Add the uncertainty caused by Brexit to low interest rates, technological change and strong competition, and it’s plain to see why optimism is falling and pressure on margins remains intense.
“With firms voicing strong concerns about the impact of Brexit, especially the risks to the wider economy in the years ahead, the Government must allay their unease with clear plans for negotiations to leave the EU. An ambitious Autumn Statement would also set a clear direction for growth and prosperity.”