The EU is proposing a model based on regulatory equivalence. As regards financial services, the EU's third country equivalence model varies somewhat according to each piece of Single Market legislation (although not all sectorial legislation includes an existing equivalence regime). Broadly, however, it involves the EU assessing whether a non-EU jurisdiction has rules which are sufficiently similar to the EU's requirements to be considered equivalent in order to permit access to EU markets. Although there is typically some ambiguity in relation to the precise manner in which these equivalence assessments should be performed, latterly (for example, in proposals amending the Markets in Financial Instruments Regulation) the EU appears to have been moving closer to more granular "line-by-line" assessments of rules in certain cases. This can be distinguished from the outcomes-focused model favoured by the UK, which gives greater importance to broader policy objectives, rather than the form of individual rules. As Philip Hammond noted in his Canary Wharf speech, the EU's equivalence regime also allows the EU to withdraw access at any time if it deems that a non-EU jurisdiction has ceased to be equivalent.
Various EU representatives such as Michel Barnier and the president of the European Council, Donald Tusk, have indicated that the UK government's stated "red-lines", such as not being subject to the jurisdiction of the CJEU, will entail consequences for the level of access that may be granted to UK firms. To date, the EU has essentially presented possibilities for the end state relationship as forming a "menu" of potential FTAs modelled on existing EU arrangements with other non-EU countries (e.g. Norway, Turkey or Canada), the availability of which is dependent upon the extent to which the UK maintains its current red lines. The UK government has rejected that approach, arguing that the UK and EU should conclude a bespoke negotiated agreement that reflects unique characteristics of their particular relationship. It is currently unclear whether the EU will be amenable to considering such bespoke arrangements once substantive negotiations begin on a potential FTA, although there have been some informal reports that certain EU Member States may be pushing for a more flexible concept of equivalence in order to ensure continued mutual access.
In its guidelines agreed on 23 March 2018, the European Council noted that it was ready to initiate work on a "balanced, ambitious and wide ranging free trade agreement insofar as there are sufficient guarantees for a level playing field". However, it went on to state that "[s]uch an agreement cannot however offer the same benefits as Membership [of the EU] and cannot amount to participation in the Single Market or parts thereof". As regards the specific position of trade in services, the guidelines expressed "the aim of allowing market access to provide services under host state rules, including as regards right of establishment for providers, to an extent consistent with the fact that the UK will become a third country and the Union and the UK will no longer share a common regulatory, supervisory, enforcement and judiciary framework". The implication appears to be that while services may form part of a future UK-EU FTA, the level of access to EU Member States may be reduced and may potentially be dependent upon national legal regimes.
LEGAL PROCESS FOR RATIFICATION OF AN EU-UK FTA
The legal process for the ratification of a future FTA by the EU depends upon whether the subject matter of the FTA falls within the exclusive competence of the EU as a legal entity, or whether part or all of the subject matter is subject to the shared competence of the EU and the individual Member States (a so-called "mixed agreement"). The delineation of the EU's exclusive competence and the shared competence of the EU and its individual Member States is set out in Articles 3 and 4 of the Treaty on the Functioning of the European Union (TFEU).
Article 3 TFEU sets out the areas in which the EU has exclusive competence, which include, amongst others, the following:
- the Customs Union;
- establishing competition rules necessary for the functioning of the EU's internal market;
- conservation of marine biological resources under the common fisheries policy; and
- the EU's common commercial policy.
By contrast, Article 4 TFEU sets out areas in which the EU and Member States share competence, except in so far as exclusive competence has been retained for the EU under Article 3. These include areas such as:
- the internal market;
- agriculture and fisheries (excluding the conservation of marine biological resources);
- the environment;
- consumer protection;
- freedom, security and justice; and
- certain safety concerns relating to public health matters.
The provisions in the EU Treaties regarding the conclusion of external agreements with third countries are complicated. In summary, where an agreement falls within the EU's exclusive competence, it is not necessary for individual Member States to ratify the resulting agreement. Instead, it is sufficient for the Council to vote to conclude the agreement, typically acting by a qualified majority. Generally, the Council is only required to consult with the European Parliament, although the consent of the Parliament is required in some circumstances – for example, where the agreement has important budgetary implications for the EU or where the agreement relates to an area that would be subject to the ordinary legislative procedure or another special legislative procedure that would require the Parliament's consent. It seems likely that any wide-ranging FTA between the EU and UK would require the consent of the European Parliament, rather than merely consultation, effectively giving the Parliament a veto right.
Conversely, a "mixed agreement" must also be ratified by each individual EU Member State in accordance with its own constitutional requirements. This can lead to the situation where a single Member State (or even a region within one) may delay or prevent the ratification of an agreement. Examples include the Netherlands' rejection of the Ukraine-EU Association Agreement in April 2016 and the Belgian region of Wallonia's initial rejection of the EU's Comprehensive Economic and Trade Agreement (CETA) with Canada in October 2016. As a result, it is likely to be procedurally (and probably politically) much easier for the UK to conclude a binding FTA with the EU if the FTA can be classified as falling within the EU's exclusive competence.
In Opinion 2/15 in May 2017, the CJEU gave an expansive interpretation of the EU's exclusive competencies under Article 3, especially as regards matters falling within the EU's common commercial policy, in the context of the EU's negotiations for an FTA with Singapore. However, even in that opinion, the CJEU noted that certain issues fell within the EU and Member States' shared competences, including certain provisions relating to non-direct foreign investment. A number of commentators have suggested that the UK's desire for a wideranging and deep FTA with the EU may point towards the use of a "mixed agreement", which would entail a lengthy ratification process by each individual Member State. Nonetheless, depending on the exact content of the proposed FTA, it may theoretically be possible to construct an agreement within the EU's exclusive competence if the agreement is more limited in scope.
The UK government's position on UK domestic ratification of the FTA is less clear, although certain statements made by ministers in the UK Parliament could be interpreted as being supportive of a parliamentary vote. It is likely that Parliament will have the power to block ratification of any FTA, although it will have very limited ability to influence the content of the relevant agreement, other than through the potential threat of nonratification. Since the terms of international treaties are not incorporated automatically into UK domestic law, if the FTA requires the UK to give effect to its provisions by amending domestic law, it is likely that new primary legislation would be required (unless ministers have been granted sufficient powers to make appropriate secondary legislation under an existing statute).
KEY BREXIT ISSUES FOR FIRMS
From the present vantage point, without the benefit of clear parameters about the future financial services relationship between the UK and the EU, it is difficult to provide a concrete assessment of whether, and to what extent, firms may need to adapt their business models. However, we have set out below some considerations which may be relevant to firms' ongoing planning in the coming months.
DURING THE TRANSITIONAL PERIOD
Assuming that the UK and the EU conclude a legally binding agreement on transitional arrangements until the end of 31 December 2020, there will be no change to the existing regime and firms may continue to rely on their current structures. This is subject to several important caveats:
- as stated above, it is still possible that although the transitional arrangements have been agreed in principle, the parties may fail to agree a legally binding version of the text, such that there is a regulatory "cliff edge" from 30 March 2019;
- before and during the transitional period, firms will need to continue thinking about how their business models will transition to the end state relationship between the UK and the EU after 31 December 2020. In practice, this may still be challenging because the final parameters of that end state may not become obvious until nearer the end of the transitional period. Firms may need to model a "worst case scenario" fall-back plan and leave sufficient time to activate it if it appears that the end state relationship will ultimately be unfavourable; and
- the UK will effectively be a "rule taker" in relation to EU laws that are adopted during the transitional period (and for all practical purposes, before it begins), meaning that it will have very limited ability to influence the development of rules that become effective during that time. In certain cases, firms may need to adapt their structure in order to comply with these new rules or to ameliorate their impact upon certain business activities.
PREPARING FOR A POSSIBLE "CLIFF EDGE"
If the UK and EU fail to agree a legally binding transitional period or if a transitional period expires without agreement on a new end state relationship between the parties, there will be a regulatory "cliff edge" (either on 30 March 2019 or on 1 January 2021, respectively). While a cliff-edge is not inevitable, as part of their scenario planning, UK firms that operate on a cross-border basis into the EU (and EU firms operating in the UK) will need to consider a range of issues, which may include those listed below.
- Where are the activities undertaken by the firm deemed to take place? Different jurisdictions adopt different approaches in relation to the same activity. For example, from a UK perspective, the activity of discretionary portfolio management is generally understood to be carried on where the discretionary decisions are made. This would mean that if these decisions are taken in the UK by individuals acting on behalf of a UK firm, the UK regulatory position is likely to be that the activity is not carried out on a crossborder basis, even if it is carried on for a client based in the EU. However, the jurisdiction in which the non-UK client is based may take a different approach (for example, by deeming the activity to be carried on where the recipient of the service is located), so firms will need to assess any potential regulatory risk carefully. Where a UK firm concludes that it is carrying on activities in another EU Member State, it will need to consider what regulatory licences, if any, will be required in that jurisdiction after Brexit.
- How does the firm attract investors or clients in other jurisdictions? The existing mechanisms for marketing financial products and services may vary depending upon the type of client to whom the marketing is directed and whether the relevant regulatory regime (e.g. AIFMD, UCITS, MiFID etc.) provides for passporting of marketing activities. Since any passports between the UK and EU will fall away, the firm will need to consider if there are other established mechanisms for marketing (e.g. the national third country private placement regimes (NPPRs) under AIFMD, if available in the jurisdiction) or, absent such a mechanism, whether the possibility of carrying on marketing will be entirely subject to the jurisdiction's national rules. Some jurisdictions may effectively be closed to active marketing. The firm will also need to consider whether its marketing activities may be considered to amount to the provision of services in the relevant jurisdiction (e.g. reception and transmission of orders, investment advice and/or placing on a non-firm commitment basis, or equivalent regulated activities undertaken in the UK) and if so, the mechanisms (if any) for providing such services lawfully and in accordance with relevant conduct of business rules. In some cases, it may be possible to rely on an argument that "reverse solicitation" has occurred – i.e. that the relevant client has contacted the firm on the client's own initiative without any prior engagement by the firm – such that no marketing is subsequently deemed to have occurred, although this would need to be approached cautiously. It may also be possible to engage local entities to undertake permitted marketing activities on the firm's behalf.
- Will the regulatory status of the product offered by the firm fundamentally change? Some funds will undergo a fundamental overnight change in their status once the cliff edge is reached. For instance, under the existing regulatory definition, a UCITS fund must be domiciled in an EU Member State. Any UK UCITSs will effectively be viewed in the remaining EU jurisdictions, at least, as AIFs and be governed by the regime for non-EU funds under AIFMD. This may have an impact on whether existing institutional investors can remain invested, or can continue to invest in the future, in the relevant fund, as their investment mandates may prohibit them from investing in non-UCITS funds or limit the level of assets that they can commit to such investments. It is unclear whether, for UK domestic purposes, the UK will continue to recognise remaining EU funds as UCITS funds (or a UK domestic equivalent) or otherwise how they would be treated from a regulatory perspective – for instance, will they be subject to the UK's domestic law version of the AIFMD regime (to match the likely view of the EU) or UCITS regime, or a hybrid of the two? There may also be an effect for existing securitisation structures where, in order to comply with retention requirements, a UK-based sponsor holds the required risk retention. It is possible that such a structure could cease to comply with investor representations in the relevant securitisation documentation and/or EU regulatory requirements for risk retentions (although this may, in part, depend upon the correct interpretation of the new EU Securitisation Regulation in this regard).
- Will re-registration or other procedural steps be required and could this disrupt ongoing activities? A change to the firm's regulatory status may mean that it is required to re-register under national rules in some circumstances. For example, where an AIF is currently marketed by a UK AIFM into other EU Member States in reliance on the marketing passport, following the cliff edge, it would need to be marketed under individual Member States' NPPRs (if permitted). This would require the AIF to be registered for marketing with each relevant national regulator separately. Until the registration process is completed (which could, depending upon the jurisdiction, take several months), the AIFM would be unable to continue marketing activities in those Member States. Therefore, if the AIFM were engaged in fundraising activities that straddled the cliff-edge, marketing of the fund could be severely disrupted during that period. It is also unclear whether the AIFM would need to register for marketing in those jurisdictions where it had already picked up investors under the passport but is no longer actively marketing, on the basis that the NPPR notification creates the necessary ongoing relationship between the AIFM and the relevant jurisdiction's national regulator for supervisory purposes.
- Can the firm rely on delegation arrangements with an affiliated entity in another jurisdiction? One potential solution that has been suggested to the lapse of passporting arrangements is for a firm to establish an affiliated entity (or use an existing affiliated entity) in the EU and indeed a number of firms have already pursued this option. Under this model, the EU affiliate benefits from passporting arrangements throughout the remaining EU Member States, but delegates the performance of certain functions back to the UK firm. Clearly, this has potential advantages in terms of allowing firms to minimise the relocation of operations from the UK to the EU. However, the firm would need to consider a number of factors before adopting this approach. For example, it would need to assess the level of substance that it would be required to maintain in the relevant EU jurisdiction in order to satisfy the threshold requirements for authorisation of the affiliated entity. It would also need to consider the potential conditions for, or limitations on, delegation under applicable EU or national rules and the manner in which UK-based staff might otherwise act on behalf of the EU entity.
- What would be the likely timeline for relocating operations and/or obtaining authorisation for a new entity? Where the firm is considering a potential structural solution which involves relocating certain of its operations to another jurisdiction and/or getting a new entity authorised, it will need toconsider the likely timeline involved. In practice, where regulatory authorisation is required, this may necessitate a longer lead time, which may minimise the firm's ability to pursue a "wait and see" strategy with regard to possible developments in negotiations. The firm will also need to consider whether timescales for authorisation may be affected by an increased volume of applications as the cliff edge draws closer and/or whether professional advisers in the relevant jurisdiction will have sufficient capacity to assist with any application where necessary. Alongside this, firms will also need to consider practical issues such as budgeting and allocation of sufficient management time to the relevant issues.
- Will the enforceability of any existing agreements be affected? Firms should consider whether the terms of any existing agreements (including those with clients, investors or service providers) are such that they would become invalid or unenforceable as a result of the regulatory cliff edge. Where necessary, firms may need to renegotiate agreements in advance of the withdrawal date in order to ensure that there will be sufficient legal certainty after that time.
ASSUMING AGREEMENT ON AN END STATE RELATIONSHIP
If an FTA is ultimately concluded between the UK and the EU that covers financial services, clearly it will be necessary for the firm to consider the viability of its existing business model under the terms of that FTA. At the present time, before substantive negotiations on the end state relationship have begun, it is difficult to predict what arrangements, if any, might eventually be agreed.
One of the potential difficulties with transitioning to the end state relationship is that, as with the current proposed transitional arrangements, nothing will be agreed until everything has been agreed. This means that while firms may be able to assess how proposals develop during negotiations in the coming months, there may be limited certainty on the final shape of the relationship until late in the process. A degree of contingency planning may therefore be required so that firms have a "worst-case scenario" fall-back option in case negotiations are ultimately unsuccessful or conclude with a sub-optimal outcome for financial services. Even if an FTA is eventually agreed, depending on its precise terms, firms may still need to consider many of the issues identified in the section above.
HOW WE CAN HELP
If you require any advice or assistance in relation to your Brexit planning, whether in terms of proposed restructuring of business operations or otherwise, please contact any of the partners named below.