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Managers could face new woes in EU because of ESMA ‘opinions’ regulator burden

Statement affects investment management, staffing, even office locations

Peter Astleford
Peter Astleford is seeing a few potential problems with some of the ESMA opinions.

A European authority's opinions on the post-Brexit treatment of U.K. money managers might cause a headache for other non-EU firms, sources warn.

The European Securities and Markets Authority, which is tasked with improving investor protection and promoting stable markets within the European Union's financial system, published its opinions July 13 detailing sector-specific principles on relocations to EU member states from the U.K.

The ESMA wants to ensure there is consistency related to the relocation of entities, activities and functions to the Continent from the U.K. The opinion specific to investment management covers principles based on the objectives and provisions of​ two European directives — the Undertakings in Collective Investment Transferable Securities and Alternative Investment Fund Managers directive. It addresses regulatory and supervisory risks relating to authorization, governance and internal control, delegation and effective supervision.

The opinions, which were issued to national regulators within the bloc, "provide guidance to (national authorities) aimed at ensuring a consistent interpretation of the requirements relating to authorization, supervision and enforcement in order to avoid the development of regulatory and supervisory arbitrage risks," said information on ESMA's website.

While the trigger for publishing these opinions is Brexit, sources warned other non-EU countries might be subjected to a higher regulatory burden.

"The ESMA opinions on outsourcing and delegation of invest- ​ ment management functions apply to all ... (non-EU) countries," said Rhodri Preece, head of capital markets policy for Europe, Middle East and Africa, at the CFA Institute in London. "The opinions effectively raise the regulatory bar for firms wishing to outsource or delegate functions, such as portfolio management or risk management."

Raising that bar means requiring written due diligence reports; adequate governance, internal controls and oversight; a minimum number of staff based in the EU entity; and being subject to EU remuneration rules.

"Significantly, the opinions state that the delegation or outsourcing arrangement cannot result in substantially more portfolio management or risk management being done in the original member state of the relocating entity — effectively constraining how much front-office activity can take place in the non-EU country," added Mr. Preece.

'Uncomfortable reading'

"ESMA's opinions on supervisory convergence relating to investment firms, investment management and secondary markets ... make uncomfortable reading for parts of the asset management industry," said Philip Spyropoulos, a senior associate in law firm Eversheds Sutherland's financial institutions team in London, in an email. "Two particular and related areas of focus were the substance of EU subsidiaries and a renewed focus on provisions against firms acting as a letterbox" entity — one that does not have the substance, knowledge or expertise to take on risk and portfolio management.

"These points are at the heart of the question facing U.K. asset managers: Can material (and valuable) aspects of EU asset management continue to be delegated, outsourced or otherwise carried on from outside the EU?"

Said Owen Lysak, London-based partner at law firm Clifford Chance: "The opinion makes it clear that so-called letterbox entities are unacceptable, with a requirement for a substantial portion of human capital to be based in the member state. This will be a critical hurdle for firms to overcome to get their new entities approved by domestic regulators."

While the opinions' stated goal is regulatory convergence, they "may instead act as a raising of standards across the board," said Mr. Spyropoulos. And it might not require a change in laws to achieve that. "Many existing requirements, such as those around letterbox entities, are phrased broadly and have the scope to be applied in more stringent ways," he said. "Anecdotally we are already hearing of overseas regulators taking a more exacting position to firms looking to implement Brexit contingencies. If the ratcheting up is too heavy-handed, firms in other non-EU countries will fear that the baby is being thrown out with the bathwater."

He added: "By targeting the U.K., ESMA is forcing supervisors to take a harder line on all non-EU entities. Non-EU financial institutions may be seen as collateral damage, as non-U.K. third-country entities are forced to revisit existing arrangements, as Europe tries to retain substance within its financial services sector."

Threat to delegation

As the law stands, Brexit should not be a major problem for U.K. money managers because of the provision of passporting or equivalent measures under UCITS, AIFMD and the Markets in Financial Instruments Directive II. Under MiFID II, managers should also be able to sell through segregated accounts assuming U.K. equivalence.

However, Peter Astleford, partner at law firm Dechert LLP in London, said this all depends on the current process of delegating the management of portfolio management for European investors and vehicles to other jurisdictions — such as the U.S. — continuing. "That has worked well without any difficulties up until now. There might now be a threat to the system of delegation," said Mr. Astleford.

While the opinions are instructions to national regulators about the practices they should follow, working to equate standards and structures across EU member states and among MiFID, UCITS and AIFMD entities, he said, "they have applied the highest, most difficult standard across the board, which currently is written into just one of these three areas, (AIFMD) … in that way they present a tightening up of what is required."

The opinion also highlights the importance of "substance," suggesting a head office have a particular size in relation to the whole company. "That has never been the law or practice — with proper procedures and systems you can have 10 people in a head office, and 1,000 elsewhere," said Mr. Astleford.

'A whole new concept'

The third issue he highlighted is the need to justify setting up in a certain country. "This is a whole new concept that you have to justify a choice of location within a common market — where there is freedom of movement — why you're setting up in Malta, Germany or France, rather than simply having the choice to set up there. This to me is a whole new departure," Mr. Astleford said.

"While most of the story is good common sense to keep standards where they should be, there are a few worrying signs. Time will tell whether this is just a blip to deal with the temporary surge in activity related to Brexit, or long term to bring in tighter rules and attempt to force businesses to move into a number of ... (EU) countries. And if they do force (that), costs will rise and, in the short term at least, service standards and choice will likely decline. That is not good for pension funds, insurance companies and other investors, because they want to have maximum choice of investment opportunity. That has already been an issue for continental investors, for insurance companies in particular, since the advent of AIFMD, and this has the potential to accelerate that move. That is not in the interest of any individual on the Continent, whether thinking about their own savings held directly or through pension funds or an insurance company," warned Mr. Astleford.