Brexit series: Brexit sector briefing: financial services and banking

Practical Law UK Articles 7-638-0364 (Approx. 5 pages)

Brexit series: Brexit sector briefing: financial services and banking

by Rob Aird, Kirsty McAllister-Jones and Bisola Williams, Ashurst LLP

Passporting

A key aspect of EU financial services law is the right afforded to a firm in an EEA member state to carry on a business in another EEA member state, provided that single market directive requirements are met in relation to the activities that are being carried out (see box "The single market and financial services"). This concept is known as passporting.

In very broad terms, passporting refers to the right afforded to a financial institution established and authorised in an EEA member state (its home member state) to carry on certain activities in, or provide certain services into, another EEA member state (the host member state), whether as a cross-border service or by way of a branch in the host member state, without the need for separate authorisation in that host member state. These are important rights which enable firms authorised as banks (both retail and investment), brokers, custodians, wealth managers, insurers, reinsurers, insurance intermediaries and asset managers to market and distribute their products throughout the EEA on the basis of a single set of permissions from their home regulator.

There is no overarching, general passporting right applicable to all financial services. The rights are instead found under several different pieces of EU legislation, such as the:

Capital Requirements Directive (2013/36/EU) (CRD IV).
Markets in Financial Instruments Directive (2004/39/EC) (MiFID) and the forthcoming MiFID II Directive (2014/65/EU) (see Briefing "MiFID II and MiFIR: preparing for change").
Solvency II Directive (2009/138/EC) (Solvency II), the Insurance Mediation Directive (2002/92/EC) and the forthcoming Insurance Distribution Directive (2016/97/EU).
Alternative Investment Fund Managers Directive (2011/61/EU) and the UCITS IV Directive (2009/65/EC).

Impact of losing passport rights

If, as seems likely, the UK does not remain a member of the EEA, firms will most likely lose their passporting rights. Broadly speaking, this means that firms which are authorised in the UK by the Prudential Regulatory Authority or the Financial Conduct Authority will either be prohibited or restricted in their ability to provide services or distribute products into the EEA. Equally, firms that are authorised in the EEA will be similarly affected when providing their services or distributing their products into the UK. For example:

A UK-authorised investment bank will likely find that its ability to market, or provide advice in relation to, securities within the EEA is at least restricted, as it will lose its rights to passport these activities under MiFID. It may have to comply with national rules in relation to these activities, at least for an interim period, rather than with the harmonised rules to which it is currently subject.
A fund that is domiciled and registered in the UK under the UCITS regime may be restricted from being marketed to retail investors within the EEA. It would likely become considered a non-EEA alternative investment fund, which may only be marketed to professional investors in the EEA on the basis of the applicable private placement rules.

The same, but not equivalent?

There are provisions within the relevant EU legislation that might appear, on the face of it, to mitigate the loss of the key passporting rights for firms. In broad terms, these provisions permit entities that are established in non-EEA countries (third countries), and have legal and regulatory requirements which are considered to be equivalent to those in the EU, to distribute products and provide services within the EEA in the same way as EEA member states; that is, without having to comply with the national laws of each EEA member state or the relevant EU legislation (other than those provisions specified as applicable to third countries), as well as their own national legislation.

This may appear to present a convenient solution for firms. As an EU member state, the UK legislation is the same as the EU legislation; indeed, in many cases, the UK has gone further and gold-plated provisions. However, there are limitations:

Equivalence is granted under specific legislative provisions, not on a general basis.
Equivalence provisions are not available under all relevant EU legislation; for example, CRD IV does not provide for equivalence status to be granted to third countries.
Where equivalence provisions are available, they are generally more limited than current passporting rights. For example, while there are equivalence provisions under MiFID II, the right for an investment firm from a third country to distribute products and provide services is likely to be limited to professional clients, and not extend to retail clients. In addition, while there are equivalence provisions in respect of certain aspects of the Solvency II Directive, they do not extend to providing passport rights for insurers.
The right to grant equivalence under the relevant legislation is reserved to the European Commission (the Commission). In most instances, there is little guidance on what a third country must do to demonstrate equivalence. Although a country with laws that are the same as the remaining member states might be expected to demonstrate a high degree of equivalence, one cannot dismiss the possibility that, due to the discretionary nature of these rights, equivalence assessments may be used as a political tool by the remaining member states. The government has announced that the Great Repeal Bill will provide for the European Communities Act 1972, the principal statute by which EU law is implemented into UK law, to be repealed, but then for EU law to be reinstated, at least for an interim period while the government assesses what must be retained, amended or permanently repealed. If negotiation of the UK"s withdrawal from the EU has not gone smoothly or has been contentious, the Commission may not grant equivalence readily.
There are relatively few instances where equivalence has been granted for third countries, and timing is likely to be an issue. It took the EU several years to grant clearing equivalence to central counterparties registered with the US Commodity Futures Trading Commission under EMIR (Regulation 2016/1178/EU supplementing the Regulation on over-the-counter derivatives, central counterparties and trade repositories) and there is currently a backlog of pending equivalence requests.
On the basis that equivalence is discretionary, it can be revoked. Although the UK is undoubtedly compliant with EU law at present, ongoing compliance is required to retain equivalent status. This is not guaranteed, and neither is the appetite of the EU regulators to continue to monitor the UK"s regulatory position.

Clearly, equivalence is not a complete solution to the loss of passporting rights. While there has been discussion of a broader equivalence agreement between the UK and the EU, which would provide firms with rights akin to passporting, it may be that the final agreement between the UK and the EU provides for, at best, a determination of equivalence for the UK where that is provided for in the relevant EU legislation and no more.

An orderly transition?

In addition to the risk of losing passport rights, and the uncertainty around what, if anything, will replace those rights, firms must also be aware that any replacement regime may not be agreed between the UK and the EU for some time. Although the government has suggested that it will formally trigger Article 50 by the end of March 2017, Article 50 does not explicitly provide that any future relationship agreement must also be negotiated in the ensuing two-year negotiation period. Comment from some sources within the EU institutions and from the remaining member states suggests that this is how the EU will approach the negotiations. It is therefore possible that, at the end of the two-year period, the UK could withdraw from the EU, losing all passporting rights and having no replacement regime or longer-term transitioning phase agreed.

Mitigating the risk

There are obvious uncertainties for firms that rely on their passporting rights. The lack of a transitional timetable, and the uncertainty over what rights might be available for UK-authorised firms to provide products or services into the EU and vice versa, give rise to significant cause for concern. It appears unlikely that these issues will become clearer in the short term, and firms may feel that they are forced to consider relocating all or parts of their business into the remaining member states to preserve their market access. On the basis of the time and resources required to do that, some may feel that they need to begin that relocation imminently to avoid any sudden loss of rights if the Article 50 process expires without a satisfactory solution in place.

However, others may decide that their businesses are, to some extent, appropriately positioned to avoid that risk by: limiting their activities in the EU to comply with national laws; ceasing to provide certain products or services; or using other entities within their group structure to conduct business previously provided from the UK. What is clear is that the financial services industry will be watching developments in the Brexit negotiations with great interest, and no shortage of concern.

Rob Aird is a partner, Kirsty McAllister-Jones is a Senior Expertise Lawyer, and Bisola Williams is an Expertise Legal Manager, at Ashurst LLP.

The single market and financial services

Over many years, the EU has evolved to provide a number of industries with a relatively clear legal framework for the free movement of goods and services. This is based on the four fundamental freedoms of the EU which are a central part of EU treaty law; that is, the free movement of: goods; services and establishment; capital; and people.

The single market has benefited the financial services industry by creating a set of harmonised rules that enable products and services relating to banking, insurance and fund management to be marketed and distributed throughout the EU. These rules mean that, in very broad terms, providers of financial services have been able to conduct their business throughout the EU with certainty as to how these products and services can be marketed and distributed, without the need to consider the disparate national laws of each EU member state.

Accordingly, Brexit is likely to affect not just those businesses that provide products and services from the UK into the EU, but also those that provide products and services from the EU into the UK (see feature article "Brexit and commercial contracts: assessing the impact").

Brexit series: Brexit sector briefing: financial services and banking | Practical Law