The European Securities and Markets Authority foresees regulatory and arbitrage risks in Brexit and has issued an opinion as a practical tool to help achieve supervisory convergence among EU regulators—Brexit negotiations begin on June 19, and Brexit is scheduled to occur on or before March 30, 2019 unless an extension is agreed.

On May 31, the European Securities and Markets Authority (ESMA) delivered an opinion (Opinion) on achieving a common approach to supervision among regulators in European Economic Area (EEA) member states in the context of the United Kingdom’s anticipated withdrawal from the European Union. This timely intervention follows in the wake of the UK’s withdrawal notification dated March 29, 2017, the European Parliament’s resolution of April 5, 2017 on Brexit negotiations with UK, and the European Council’s Brexit guidelines of April 29, 2017.

ESMA concedes in the Opinion that “the UK plays a prominent role in the EU Single Market,” and bases the Opinion on the fact that the relocation of financial firms, activities, and functions following the UK’s decision to withdraw from EU creates what ESMA describes as “a unique situation which requires a common effort at EU level to ensure a consistent supervisory approach to safeguard investor protection, the orderly functioning of financial markets and financial stability.”

It is commonly accepted that UK-based financial market participants planning for a worst-case “hard” Brexit scenario—whereby the UK becomes a regular “third country” and UK participants lose all of their single-market passporting rights—are giving serious consideration to setting up affiliates in one of the other EU countries (EU27) in order to seamlessly retain passporting rights through and beyond Brexit. ESMA realistically acknowledges that UK participants will seek to minimize the transfer to the EU27 of those activities’ effective performance by relying on the outsourcing or delegation of certain activities to UK participants.

Accordingly, the Opinion assumes a “hard” Brexit and no special bespoke deal with the UK on single-market access. The Opinion does, however, leave the EU27’s door open to a bespoke deal by specifically stating that its “hard” Brexit assumption “is without prejudice to any specific agreements that may be reached between the UK and the EU27.”

The Opinion focuses on the activities of alternative investment fund managers (AIFMs), management companies of UCITS funds, and MiFID firms seeking establishment within the EU27.

It is fair to say that while certain functions and activities may be relocated from the UK to the EU27, to date there has not been any hint that UK firms would relocate lock, stock, and barrel to the EU27—instead, the expectation is that firms will retain modified versions of their UK structures and be co-located in the EU27.

General Principles

The Opinion enumerates the following nine principles:

• There should be no automatic recognition of existing authorizations of UK firms post-Brexit.

• Authorizations granted by EU27 regulators should be rigorous and efficient.

• EU27 regulators should be able to verify the objective reasons for relocation and only confer authorization if they are satisfied that the member state of an establishment was not chosen to avoid more stringent standards prevailing in other member states. Regulators should particularly scrutinize applications where it appears that an entity intends to pursue the greater part of its activities in other member states.

• Avoid letter-box entities. This principle is aimed squarely at the possibility that UK firms will relocate within the EU27 to retain passporting rights but then delegate substantial activity back to the UK, leaving the firm in the EU27 a mere “letter-box.” Regulators should reject any relocation request creating letter-box entities where, for instance, extensive use of outsourcing and delegation is foreseen with the intention of benefiting from an EU passport while essentially performing all substantial activities or functions outside the EU27;

• There should be strict conditions for outsourcing and delegation to third-country (e.g., post-Brexit, UK) firms. Only tasks or functions can be outsourced or delegated, not responsibilities.

• Substance requirements should be met—EU27 regulators should be informed about outsourcing and delegation and be able to supervise firms, including by having access to data and to the business premises of the delegate. Certain key activities and functions should be undertaken in the EU27, including at least the bulk of decisionmaking. In certain sector-specific circumstances, important activities and functions, including internal control functions, IT control infrastructure, risk assessment, compliance functions, and key management functions, cannot be outsourced and delegated.

• There should be sound governance—key executives and senior managers of EU27 authorized firms should be employed in the member state of establishment and work there to a degree proportionate to their roles, but not necessarily full time.

• EU27 regulators must be able to supervise and enforce EU law effectively. In the case of outsourcing or delegation, ESMA expects that regulators should be able to conduct on-site inspections of outsourced or delegated activities without any prior third-party authorization.

• There should be coordination among regulators to ensure effective monitoring by ESMA, which includes initiating investigations of possible breaches of EU law.

Although these principles are expressed in general terms, in a number of respects, they seem to impose requirements beyond those in the underlying directives. Much will depend upon how these principles are interpreted and applied by individual regulators. At the very least, UK firms seeking to establish a business presence in the EU27 will need to give detailed consideration and focus to the resources and operational substance that will need to occur in the jurisdiction in which that presence is established.

ESMA indicates that it will be developing further specific guidance for asset managers and investment firms. This further guidance seems likely to elaborate on the general principles summarized above. We will keep you updated on these developments.