Fund-mageddon: Investment Schemes and Fund Managers post-Brexit.
On the 29th March 2017 the UK Government notified the European Council of its intention to withdraw from the European Union (EU) pursuant to Article 50 of the Treaty on European Union. The post-Brexit legal landscape remains uncertain, as does the UK’s future access to the single market. Assuming no agreement is reached and the UK leaves the EU and the European Economic Area (EEA), UK fund managers and UK domiciled investment schemes could lose the ability to passport. It is this potential loss of the passport which has UK fund managers considering their options for survival in a post-Brexit Britain.
As of the end of Q1 2017 there were approximately 1,974 UK domiciled UCITS funds. When the UK leaves the EU and presumably the EEA, these funds will no longer be capable of authorisation as UCITS as they will fall outside the scope of the legislation. For UK domiciled UCITS which have been marketed cross border within the EU and EEA this creates a problem, as the passport provisions which allow them to be managed and marketed in other EEA Member States would no longer apply.
The UCITS passport provides that once a fund is authorised as a UCITS in one Member State it can be marketed cross border in other EU and EEA Member States without having to be further authorised by the host state regulator. Post-Brexit, the UK may cease to be an EU and EEA Member State, and consequently UK UCITS funds will not be capable of continued authorisation as UCITS. It is likely that post-Brexit, UK fund structures authorised as UCITS will need to be re-classified under another name as a type of ex-UCITS fund.
The majority of UK UCITS funds are marketed only to domestic investors. Brexit should therefore not pose any significant challenges to these funds as no passport would be required to market them. On a practical level however, and in consideration of the above, they would no longer be UCITS funds for EU law purposes. They may therefore need to issue up to date constitutional documents reflecting any changes in name and regulation as ex-UCITS funds. On a positive note, whilst UK ex-UCITS may not be able to target European retail investors in the wake of Brexit, they could potentially still be marketed globally via the individual private placement regimes of other non EU countries. Of course UK funds marketed in this way would be subject to the laws of each individual country and any future trade agreements negotiated by the UK Government.
For UK managers currently managing EU and EEA UCITS schemes there are significant challenges to overcome in a hard Brexit scenario. UK managers can currently manage and distribute EU and EEA UCITS funds by virtue of the UCITS passport which allows an EU management company to manage a UCITS domiciled in another EU or EEA Member State. They can then market that UCITS cross border throughout the EU and EEA. As stated above, the management company of the UCITS must be established in an EU or EEA Member State, which post-Brexit could result in the loss of the passport rights for UK managers.
One possible solution is to have the EU or EEA domiciled UCITS appoint a new management company established in an EU or EEA Member State and have this entity delegate to the post-Brexit UK entity as a type of sub-manager. For example, the UCITS itself could be registered in Luxembourg with the management company of the UCITS established in Ireland, and the Irish management company would sub delegate certain management functions back to the UK based entity.
Ireland and Luxembourg are two of the main domiciles for UCITS funds with 4,100 and 9,879 funds respectively at the end of Q1 2017. UK fund managers already often act as sub-managers via delegation agreements for these funds. Article 13 of the UCITS Directive allows for the delegation to third country entities with caveats that liability of the management company shall not be affected by such delegation. On the 31 May 2017 the European Securities and Markets Authority (ESMA) published a general opinion covering delegation and outsourcing arrangements in relation to the UK’s withdrawal from the EU. The opinion states the following:
“Any outsourcing or delegation arrangement from entities authorised in the EU27 to third country entities should be strictly framed and consistently supervised. Outsourcing or delegation arrangements, under which entities confer either a substantial degree of activities or critical functions to other entities, should not result in those entities becoming letter-box entities.”
It seems that whilst delegation arrangements are permitted and could be a viable solution for UK fund managers post-Brexit, the EU are actively trying to prevent the creation of letter-box entities in existing Member States.
Alternative Investment Funds (AIFs) and Alternative Investment Fund Managers (AIFMs) post-Brexit
The impact of a hard Brexit scenario on AIFs and AIFMs is likely to be quite different than the impact on UCITS as described above. It’s important to note from the outset that there are different types of AIFMs in the UK which can be divided broadly into two categories as follows:
1. UK AIFMs managing AIFs domiciled outside of the EU and EEA (non-EU AIFs), for example investment schemes domiciled in the Cayman Islands.
2. UK AIFMs managing EU and EEA domiciled AIFs, for example, investment schemes domiciled in Ireland or Luxembourg.
In relation to the first category, UK AIFMs managing non-EU AIFs, at present AIFMs falling within this category do not have access to the AIFMD marketing passport. These funds are marketed in accordance with Article 36 of AIFMD and the National Private Placement Regimes (NPPR) on a country by country basis. NPPR allows AIFMs to market AIFs that otherwise cannot be marketed under the AIFMD domestic marketing or passporting regimes.
Put simply, today a UK AIFM would use Article 36 of AIFMD and NPPR and in the future, after Brexit they will use Article 42 of AIFMD and NPPR. Article 42 of AIFMD states:
“Without prejudice to Articles 37, 39 and 40, Member States may allow non-EU AIFMs to market to professional investors, in their territory only, units or shares of AIFs they manage”
According to the FCA website eligible AIFMs can continue to avail of NPPR until at least July 2018. In reality, NPPR is likely to remain as the only route to market for non-EU AIFs and non-EU AIFMs until ESMA concludes its review in relation to the extension of the AIFMD passport to third countries, which is discussed below.
In relation to the second category, UK AIFMs which manage EU AIFs, the passport is available under AIFMD. In a hard Brexit scenario these AIFMs would lose access to the passport as the UK would effectively become a third country, which is to say a non-EU country. With the loss of the passport, fund managers would lose the ability to freely market their funds throughout the EU and EEA. One solution, similar to the solution provided above for UCITS, is to set up a new AIFM in an existing EU Member State and have this entity delegate certain management functions back to the UK entity.
Another possible solution to the challenges raised by Brexit is that AIFMD also contains provisions for passport rights to be extended to third countries in the future under certain conditions and this passport extension could benefit both categories of AIFM. Before the passport can be extended, ESMA need to review the non-EU country and give a positive assessment. So far, ESMA have reviewed 12 non-EU countries and given a positive assessment to nine, including Canada, Switzerland and Japan. As such, for UK fund managers to continue to have access to a passport post-Brexit under AIFMD, ESMA would need to review the UK positively as a third country.
UK Fund managers could then, as an example, apply to Ireland’s Central Bank or to the Commission de Surveillance du Secteur Financier in Luxembourg as the competent authorities in the Member State of Reference to gain access to the passport as a non-EU AIFM. If these conditions are met, the UK fund manager would be granted a passport by virtue of being authorised by an EU Member State of reference which has already implemented AIFMD and by the UK fund manager agreeing to comply with the rules of AIFMD. Crucially, the UK does not by extension need to comply with AIFMD directly or have equivalent rules in place, although in reality the UK has already implemented AIFMD via domestic legislation anyway.
It seems logical to assume that ESMA would review the UK positively in relation to the extension of the third country passport post-Brexit given its status as an ex EU country. It would be difficult for the EU to justify granting the passport to countries like the US and Japan and not to the UK as an ex-EU law compliant country, which has already implemented AIFMD.
As explored above, there are a number of practical options open to investment schemes and their managers, some in their control and others dependent on further legislative developments. Brexit is a political minefield and as such it is important to emphasise that the scenarios contemplated above could, and most likely will, become unraveled in some shape or form by future, multifaceted political agendas. Unfortunately for investment schemes, their managers and their investors the future remains uncertain and to some extent out of their control.
European Fund and Asset Management Association – Quarterly Statistical Release (June 2017 No 69)
European Securities and Markets Authority – General Principles to support supervisory convergence in the context of the United Kingdom withdrawing from the European Union (31 May 2017)
Financial Conduct Authority – National Private Placement Regime
ESMA’s advice to the European Parliament, the Council and the Commission on the application of the AIFMD passport to non-EU AIFMs and AIFs (12 September 2016)
Gary joined FinTrU in September 2015 as part of the second Financial Services Academy. He graduated from Queen’s University Belfast with an Honours Degree in Law
Previously, Gary spent three years working as a Legal Analyst for the Northern Ireland Civil Service Leading agency research projects as part of preparation for the implementation of the European Union 3rd Directive.
At FinTrU, Gary works as part of the Prime Brokerage Legal team for a Tier 1 Investment Bank. He mainly deals with Cash Payment Authorisations, which allow funds to make online and cash payments with his client as Prime Broker. Gary also reviews, sends, and approves documents to change Investment Manager and amends/terminates ISDA agreements. Another part of his role is to issue drafts for Electronic Trading Agreements and Blue Book Amendments.