BREXIT and Passporting (advising clients in the EU)
This Blog is a summary the BREXIT implications for MiFID and non-MiFID investment firms (including IFAs) when it comes to advising clients in the EU. It follows from an article by Jake Green and Qalid Mohamed both of Ashurst LLP.
Background
We have previously reported that if the United Kingdom leaves the European Economic Area (EEA) without a ratified transition period or alternative mutual access (a no-deal Brexit), UK MiFID investment firms (for the purposes of this Briefing, UK firms) will lose the right to passport their regulated services in the EEA.
We have also said that even if we get to a no deal BREXIT, the FCA have unilaterally provided a transition period for UK firms. The difficulty with passporting is we can’t dictate to the EEA countries.
This Briefing deals with a situation where the EEA countries control the situation.
It also deals with MiFID Article 3 exempt firms (Article 3 firms), which don’t have passporting rights (most IFA firms).
In a no-deal situation UK firms will have two options; they could service EEA-based clients by either:
Using an appropriately licensed EU affiliate, with the requisite passporting rights.
Complying with the licensing requirements of each EEA member state in which they wish to provide services, either by
- establishing a licensed branch in that member state (in most cases highly impractical, and unprofitable), or
- by relying on a local exemption, if it exists, accepting in each case that market access will be limited to the relevant member state’s territory.
In this Blog, we review a range of possible short-term “fixes” (we’ll call them mitigants) that UK firms might be able to fall back on as a means of managing the likely immediate impact of a no-deal Brexit on their EEA clients
The mitigants are generally viewed as any or combination of the following:
- A Characteristic performance test. The regulated activity or service is said to take place outside of a given member state’s jurisdiction.
- Reverse solicitation. With sufficient evidence, the UK firm may contend that it is providing the relevant service at the exclusive initiative of the EEA client(s), therefore exempting the UK firm from local licensing requirements.
- Agency trading. Where the UK firm has an EUIF, the EUIF buys the relevant services from the UK firm, typically on behalf of the EEA client.
Lets look at each of these mitigants in turn.
Characteristic performance test (CPT)
The basic premise of the CPT is that a regulated activity should be regarded as carried out at the place where the service is provided. This leads to the conclusion that where the particular service that a UK firm offers is not deemed to be carried out in a member state, the UK firm should not need to comply with the licensing requirements of that member state.
This is essentially the position that non Article 3 firms have taken for EEA clients in the past, and is the current position.
However there have always been, and will continue to be, limitations with the CPT.
It is neither binding or followed consistently by member states. The FCA confirms this in its Handbook, noting that member states “may take a different view… some… may apply a solicitation test” (SUP App 3.6.8G). Therefore, UK firms relying on the CPT must undertake (and should always have taken) an activity-by-activity assessment on a country-by-country basis, with the risk that they may find themselves able to rely on the CPT in only certain member states and in relation to only certain activities.
As an example, take a UK firm that receives an order, in the UK, from a client in EEA country A to invest in a GIA. Here, the FCA would likely view both the act of receiving the client order and its subsequent execution as taking effect in the UK. However, the country A regulator may view both ,or at least the execution, as taking effect in in country A. There is therefore a risk that UK law could hold that a given regulated activity is occurring in the UK, while country A law could, conclude that the activity is occurring in country A. For this reason, the CPT needs to be used with care.
Reverse solicitation
An alternative to relying on the CPT is the concept of reverse solicitation under article 42 of the MiFID II Directive and recital 43 to MiFIR (the Markets in Financial Instruments Regulation).
Using reverse solicitation, UK firms could theoretically provide investment services to EEA clients after a no-deal Brexit where certain conditions are met. The relevant conditions are that the UK firm:
- Can evidence that the relevant service was provided at the initiative of the EEA client.
- Provides only the “categories” of products and services requested by the EEA client.
- Does not solicit, promote or advertise, any new products or services (in any way) to the EEA client.
As with the CPT, the reverse solicitation exemption is not watertight. Reverse solicitation, although recognised under EU law, is not harmonised across the EEA, nd would therefore likely be a matter for each EEA country.
It is also difficult to evidence whether a client genuinely initiated a transaction. There are two related concerns here:
- Certain business models by their very nature involve continuous client interaction (across a range of communication channels). For example, this is true of IFA businesses. Therefore it is very difficult, in all circumstances, to “control client coverage behaviour” or provide a sufficient audit trail to evidence client initiation.
- If UK firms attempt to mitigate the above risk by actively seeking to evidence client initiation before Brexit, there is a real risk that a regulator would view this either as a form of solicitation in itself, or an attempt to circumvent local licensing laws. UK firms must therefore balance the need to inform clients of the likely impact of Brexit on their ability to continue to service them, as has been recommended by ESMA (we flagged this in a previous Snippet), with the need to operate within the parameters of the reverse solicitation framework.
UK firms would likely be limited to the particular service or activity requested by the client. It is unlikely that UK firms would be able to rely on broadly drafted framework contracts, permitting UK firms to market or introduce new products to EEA clients, in the expectation that where the EEA client subsequently requests the relevant service, the request would suffice to evidence reverse solicitation. However, UK firms would likely be permitted to offer similar products to those previously requested by clients.
Agency trading
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The agency argument may be formulated in various ways. Firstly, it could be structured as a traditional agency relationship between the EEA client and the EUIF. The EUIF would have terms of business with the EEA client and classify the latter as a client for regulatory purposes. The terms would make clear that the EUIF may execute orders in the name and on behalf of the EEA client (at the latter’s initiative) with the UK firm. As such, the EEA client would place the order with the EUIF rather than the UK firm. The EUIF would then fill the order through the UK firm, who would in turn execute the order.
Under this structure, the arranging activity of the EUIF would likely be viewed as taking effect in the EEA (following the CPT or the reverse solicitation test). The service would likely be viewed by EU regulators as being provided by the UK firm, from the UK into the EEA, to the EUIF. The UK firm would therefore have accepted this service at the initiative of the EUIF, which allows the UK firm to provide regulated services in the EEA without needing to be authorised.
The perceived benefit of this structure is that the UK firm may be able to control its interaction with the EUIF, and potentially be better placed to evidence reverse solicitation, than were it interacting directly with the EEA clients. The EUIF must however ensure that it does not create the impression that it is soliciting clients for or on behalf of the UK firm.
Alternatively, the agency relationship can be structured so that the EUIF acts as agent of the UK firm. In this situation, the EUIF would be dealing on behalf of the UK firm with the EEA clients.
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With both the above agency structures there are a number of limitations. Most significantly, an EU regulator may look through the agency relationship and conclude that the EUIF is, in effect, soliciting clients on behalf of the UK firm.