Although the current impasse in the Brexit negotiations may yet be resolved, there does remain significant nervousness that the UK could be heading for a “cliff-edge”, disorderly Brexit in March next year. That anxiety is justified, and all sensible businesses have been preparing themselves for that outcome – or at least working out whether they can still afford to wait and see what happens over the coming months.
In general, regulators have been slower to respond. Following a flurry of intense activity since the summer, preparations in the UK are now fairly well advanced. There is much more to do, but some of the main implications of a hard Brexit for UK-based private equity funds and their European investors are starting to become clear. But the same is not true across the EU, and market participants are entitled to expect more from the relevant supervisors.
Clearly the UK has the biggest task, and many UK-based fund managers and investors have more to lose from a cliff-edge outcome than their other EU-based counterparts. So, for example, we have now seen detailed regulations published in draft form that will replace the Alternative Investment Fund Managers Directive from March 30 next year (assuming that no transitional period can be agreed) and, as expected, these largely take the existing rules and “onshore” them. No substantive changes are made to the AIFMD regime, other than those thought necessary to make sure that the UK rules work properly. So, for instance, powers of the European regulatory authorities are transferred to the corresponding UK authority (generally the Treasury or the FCA in place of the European Commission and ESMA).
There are a few changes that may raise some eyebrows. For example, any fund marketed in the EU since 2014 (when the AIFMD became fully effective) must comply with certain notification and “anti-asset stripping” rules when it invests in larger EU-based portfolio companies. Because the revised UK rules will treat other EU countries as “third countries” when the UK leaves, these obligations will, to the extent that they apply to AIFMD-regulated UK firms, only apply when an investment is made into a UK company. If the FCA will, from Brexit, only concern itself with activities that UK firms conduct in the UK, it is unclear how EU regulators will have any recourse to UK firms that marketed their funds under the passport before Brexit, and how those EU regulators could enforce the rules that firms have previously accepted.
That – and similar regulatory gaps – are unhelpful and will cause some concern for EU regulators (and perhaps to the FCA, to the extent that a symmetrical approach is taken by the EU). They are obvious examples of the types of issue that could easily be worked out if UK and EU regulators and policy-makers can co-ordinate more effectively, and reach a deal on financial services (even if that deal is limited in scope).
At the same time, the UK has laid out its plans for a “temporary permissions regime” that will allow EU-based firms who currently benefit from market access using an EU passport to continue to do so on similar terms for a period of up to three years. That, it is hoped, will facilitate a smooth transition and will preserve access to EU funds for UK-based investors.
The UK rules are not yet perfect, and the FCA rulebook changes are out for consultation until December, so not yet settled. In addition, there will be transitional difficulties that have not yet been addressed: for example, UK insurers that have invested in EU (non-UK) private equity funds might well face an increased capital requirement if the pan-EU Solvency II rules are “onshored” in the manner currently anticipated. The UK Treasury has announced that it will give regulators the power to vary or waive regulatory requirements on a temporary basis to ensure that “changes to firms’ regulatory obligations do not pose a risk to … financial stability, the safety and soundness of firms, policyholder protection, market integrity, and consumer protection”. This power could prove very helpful and may, for instance, be used to help UK insurers who might otherwise face a sudden need to increase capital reserves without any obvious corresponding change to their risks.
However, legislators and regulators across the EU have not been so proactive in seeking to facilitate a smooth transition. Some regulators (including the AMF in France and BaFIN in Germany) have asked incoming UK firms (and domestic firms with UK clients) for disclosure of their Brexit preparations, but have not taken steps to accommodate Brexit by, for instance, including grand-fathering arrangements in their rule book. Of course, such grandfathering would have to be authorized by legislation, but regulators do have discretion in certain areas and have so far not been clear about how they can use that discretion to mitigate cliff edge risks. Given that market stability ought to be one of their central objectives, that is concerning – and could damage investors and managers.
Even the question of whether EU national regulators will enter into essential “co-operation agreements” (that would, for example, facilitate the management of EU-based funds by UK-based managers) remains outstanding. It was encouraging that ESMA recently announced that it will aim to have such agreements in place before March 2019, but less encouraging that work on that project was (apparently) not already well advanced. More broadly, the cliff-edge risk for UK firms has not been addressed at all by European regulators and policymakers. There is not yet any indication that an equivalent to the UK’s temporary permissions regime will be introduced (with consequent disruption to many EU-based market participants), no clarity on how UK-based managers can continue their ongoing fundraisings, and no announcement that emergency measures will be used to ease any transitional pain for EU-based investors.
No deal still seems unlikely, but it is a distinct possibility for which prudent businesses must plan. Regulators have a responsibility to help them to do that, and so far their response has been slow (although, to be fair, national regulators will expect the EU authorities to take the lead). The UK is certainly catching up – producing a significant volume of material in the last few weeks for firms and industry associations to wade through – and is demonstrating a desire to ease the cliff-edge risks that firms will face. It is time for the European Commission to do likewise, and for ESMA and national regulators to support and encourage that.
Simon Witney is special counsel and Patricia Volhard is a partner at Debevoise & Plimpton.
This is part of a series, European Funds Comment, by Debevoise & Plimpton.