The vote by the UK electorate to leave the European Union has created an enormous sense of uncertainty for asset managers, both those based in the UK and those who have used the UK as their base for their European operations. We asked Devarshi Saksena, Partner at Simmons & Simmons, and Art Markham, Managing Associate at Simmons & Simmons, for their views on what lies ahead for hedge funds in light of last month’s remarkable events.
While the UK electorate has voted to leave the European Union, the referendum is not legally binding. Article 50 of the Treaty of Lisbon must be invoked by the UK Government before the process of negotiating the UK’s exit can begin, and it is still not clear whether the Government will need to go to Parliament for a vote before it does so. We are navigating uncharted waters, and it is not clear when and indeed if the UK will invoke Article 50.
THFJ: What should hedge funds be considering in the wake of this momentous vote?
DS: The decisions of politicians will determine how things now play out, and the impact of Brexit on the political situation in Westminster, and in Brussels for that matter, can hardly be underestimated. It is very hard to make reliable predictions for events over the next few months, but the vote could have a serious impact on some fund managers, and they should be examining their situation and, if necessary, exploring the options now rather than waiting to see how events might develop further.
AM: There will be no one-size-fits-all solution for hedge fund managers. If, as a UK manager, you manage funds or accounts in the EU, you may need to consider how Brexit will affect those activities and start thinking about making changes to your business structure to ensure that you can continue to do so. That might mean looking at establishing a regulated hub in the EU – for example in Ireland or Luxembourg. If, on the other hand, you have no EU clients, you might not need to make significant changes to your business at all. The first thing is to have done the analysis.
THFJ: How will access to the EU’s single market by UK hedge funds be affected?
DS: Everything will depend on what sort of exit the UK manages to negotiate. Will the UK remain in the European Economic Area (EEA), thereby potentially retaining single market access? If the UK does not join the EEA, will it nevertheless be able to agree some other kind of access to the single market? We don’t yet know. Given the importance of the financial services industry to the UK, the requirements of fund managers and other financial services firms ought to be high on the agenda, at least on the UK side, but anything is possible. It is best to be developing contingency plans for a situation after Brexit where there is no single market access for UK fund managers.
THFJ: What will be the immediate effect of Brexit on UK hedge fund regulation?
AM: At first sight, the potential regulatory shift seems more dramatic than we expect it to be in practice. Unless action is taken by the UK, EU Regulations such as EMIR, SFTR, MiFIR and others, which are directly effective across the EU without any action by member states, would automatically cease to have effect. UK secondary legislation or regulations passed under the European Communities Act 1972 to implement EU Directives would automatically fall away if the European Communities Act was repealed. On the other hand, UK primary legislation that was brought in to implement an EU Directive, such as the Data Protection Act, would remain in place unless repealed by Parliament.
In practice, though, we don’t expect the UK Government to allow EU-derived laws to fall away in such a piecemeal and unplanned manner, or in many cases at all. Rather than repealing the European Communities Act, it seems more likely that Parliament will amend it so as to retain, until further action is taken, all of the EU rules implemented under it. Furthermore, it seems likely that those directly effective EU Regulations will be given continuing effect after Brexit through special UK legislation, in order to allow any transition to be carried out more smoothly.
This makes some assumptions about how the UK Government and Parliament plan to approach the process, which I doubt they yet know themselves. But it is clear that the process will need to be orderly, and repapering all UK regulations derived from EU law is not something that could be achieved by Parliamentary draughtsmen within the expected Brexit timeframe.
Much EU legislation will also continue to affect hedge funds regardless of Brexit, especially in areas where interaction with EU counterparties exists – for example, short selling on EU venues.
THFJ: How will UK regulation change over time following Brexit?
DS: For the regulatory regime applicable to UK firms, we don’t actually expect many major changes to result from Brexit. It’s important to realise that much EU financial services regulation is either driven at a G20 or OECD level, or has come from the UK itself. For example, EMIR is an OECD initiative and has had buy-in from the FCA. So, even if EMIR itself is no longer directly effective, the UK is likely to bring in an equivalent regime for policy reasons.
Changes are likely to follow careful consideration and a consultation process, as is generally the case for major regulatory changes. Another important deterrent to change is that amending much of the regulation applicable to hedge fund managers would reduce the UK’s chances of its regulatory regimes being deemed equivalent for the purposes of AIFMD and MiFID II. It therefore seems quite likely that much legislation derived from MiFID and AIFMD, and other legislation with equivalency regimes, will not be amended at all.
THFJ: You mentioned “equivalency” under AIFMD and MiFID II. What is the relevance of that?
AM: Currently, the AIFMD passport is only available to EU managers of EU alternative investment funds. However, AIFMD allows the EU Commission to extend that passport to non-EU managers so that, in effect, a non-EU manager can obtain the benefits currently available only to EU managers managing EU funds. The Commission is currently in the process of assessing individual countries for eligibility, and part of that process is to assess whether third countries have equivalent regulatory regimes. Similarly, under MIFID II, managers in approved non-EU countries could be allowed to provide investment services across the EU on the basis of third-country access provisions, partly in reliance on the regulatory authorisation that they hold in their home country, and one of the conditions for approving a non-EU country for this purpose is a declaration by the EU Commission that the country in question has an equivalent regulatory regime. These third country equivalence regimes could be a way for UK managers to access the EU after Brexit. However, to access them the UK would need to retain equivalent regulatory regimes, and that seems likely to be the approach taken by the UK on a policy level if no other kind of access to the single market is available to UK firms.
DS: These third-country regimes could prove to be very important to the UK in the future, though there are significant caveats. In particular, it is optimistic to expect that the UK could make use of either regime immediately upon Brexit. A decision was supposed to have been made on AIFMD third-country passports in 2015, but that process is moving slowly and is still ongoing. MiFID II, meanwhile, is not yet even in force. In both cases, we do not yet know just how equivalent a regime will need to be, or how long it would take for the European authorities to grant the UK a declaration of equivalence. One assumes that there will be a large political element to any such decision.
AM: We don’t suggest that managers should plan to rely on the third-country passport regimes following Brexit – if they do become available to the UK, it will probably be in the medium or long term. However, their existence is likely to influence UK decisions on regulatory policy.
THFJ: So, what options might UK managers look at to permit them to manage EU clients?
DS: For managers who need to operate in multiple European jurisdictions, the most comprehensive option would be the establishment of a European hub. This is a regulated EU entity that can operate across Europe in the same way that a UK firm does now, and which can delegate investment management decisions to the post-Brexit UK. It is likely to require some presence in another European jurisdiction.
A variant of this is to consider engaging a third party AIFM that carries out risk management functions. These are already available in Ireland, Luxembourg and elsewhere. In this way, any EU funds would have EU AIFMs, and could therefore still be passported throughout Europe for marketing while still delegating portfolio management to the UK.
AM: Beyond the hub option, managers can look at obtaining whatever local European licence is required to manage the relevant client. This might not always be more practicable than the hub option, however. Managers will need to consider their own clients and their own situations.
An option worth considering, although it won’t work in many cases, is moving the fund or managed account vehicle itself. It may be possible to redomicile it outside the EU, or in an EU jurisdiction with a more suitable regulatory regime. It might go without saying that this is entirely dependent on whether that would work for the investors.
THFJ: Under what terms would managers based in the UK still be able to market to the EU?
DS: Following a full Brexit, it will most likely be possible for UK AIFMs to market hedge funds to EU professional investors under the various national private placement regimes (NPPRs) in EU member states, after making a filing under Article 42 of AIFMD. That is the same process currently used by US managers, for example.
The NPPR regimes were originally due to be switched off as early as 2018, but because of the delays in introducing the third-country AIFMD passport, which is linked to the termination of the NPPRs, that now seems unlikely to happen until at least 2020 and possibly later.
AM: The Article 42 process is quite similar to the so-called Article 36 process that UK managers currently follow. It requires reporting to be made to more regulators, but on the other hand there is no accompanying obligation for funds to have appointed a depo-lite provider.
THFJ: How will marketing into the UK from outside the EU be affected?
AM: As with the broader AIFMD regulatory regime, the Government will probably not try to change the AIFMD-based rules immediately upon Brexit. However, this could be an area where EU rules could be repealed without affecting the EU’s equivalency determination. That could mean that, in the medium term, the AIFMD regime could be removed for marketing AIFs into the UK, and we would revert to something like the pre-AIFMD position, though perhaps retaining some elements of it. It remains to be seen what the FCA believes will be appropriate at a policy level.
THFJ: What should fund managers be doing now?
DS: We are in the early days of what will be a long and complex process. While we still face a great deal of uncertainty, fund managers should be planning for some kind of realignment of their businesses, depending on where their priorities lie. Managers should ask themselves, in particular, how important their European client base is. We expect more firms to start assessing what different EU locations can offer them in respect of continued access to Europe.
Some managers, particularly those with more complex businesses, might need to push forward with reorganisation and regulatory processes now, to give themselves enough time to ensure that their businesses maintain full compliance after Brexit. Many of the banks started their planning months ago, although, as any bank reorganisations are of course likely to take longer than will be the case for most fund managers, they have less scope to wait to see how developments unfold. We would also caution against knee-jerk reactions.
AM: It is also important not to forget that Article 50 has not yet been invoked, and the Brexit process will be a reasonably long one. In the meantime, business can still be done in the EU in exactly the same way as it is now.
DS: Ultimately, it is to be hoped that some form of common sense system of regulation and passporting will come out of any talks, allowing the asset management sector to continue to do business with a minimum of disruption.