On 23rd June 2016 the United Kingdom referendum on whether or not to remain in the European Union resulted in a majority of 51.89% of those voting wanting to leave the EU. Whilst the UK Government has yet to invoke Article 50 of the Treaty on European Union, which sets out the process by which countries exit the Union, it is clear that major changes are going to be felt across the UK and, to a lesser extent, the Crown Dependencies (including Guernsey).
Rather than deal with the wider Brexit issues, this article will focus on the expected impact on fund distribution.
The situation is currently as it was prior to the referendum and will remain as such until the Article 50 negotiations are concluded and the UK’s membership of the EU comes to an end. This means that in the UK, funds are constituted in accordance with one of two EU Directives – UCITS (Undertakings for Collective Investment in Transferable Securities) or AIFMD (Alternative Investment Fund Managers Directive).
The UCITS (currently in its 5th iteration) was the first of the two directives introduced to allow funds to passport throughout the European Union and European Economic Area. UCITS was specifically designed to meet strict requirements for sale to retail investors and as such has strict investment & borrowing restrictions. The ability to utilise a UCITS fund passport is only available to members of the EU & EEA and there are no provisions to extend the UCITS passport to non EU/EEA countries (third country).
The Alternative Investment Fund Managers Directive came into operation in July 2013 with a one-year transitional period. This covers all funds (in the directive defined as “collective investment undertakings” and named Alternative Investment Funds or AIFs) that are not already covered under the UCITS directive. Unlike UCITS, AIFMD focuses on the distribution of funds to institutional investors and, as it is designed to capture everything not covered by UCITS, there are no investment / borrowing restrictions.
Under AIFMD there are provisions dealing with the sale of third country funds into the EU & EEA under National Private Placement Regimes (NPPR) on a country-by-country registration basis. Not all EU/EEA countries transposed this part of the directive or otherwise allow such private placements (i.e. the regulator in that country has not signed a Memorandum of Understanding with the relevant third country regulator). In some countries the requirements for registration are onerous and thus discourage third country fund registration.
The directive allows for the possible future extension of the passport to third countries, which is currently progressing for a number of third countries. There are also provisions dealing with the marketing of AIFs to retail investors with EU/EEA countries able to allow retail marketing with the addition of such additional regulation as they deem necessary and appropriate.
Guernsey is not part of the European Union or the European Economic Area. Funds established in Guernsey do not, therefore, have access to the UCITS passport. Before the implementation of AIFMD there were various routes by which Guernsey funds could be sold into the UK:
- Guernsey open-ended class “A” funds could register for marketing to retail investors under section 270 of the Financial Services and Markets Act 2000 (FSMA), which was possible as class “A” funds were designated by Her Majesty’s Treasury under s270
- Other Guernsey funds could apply for recognition under section 272 of FSMA on a case-by-case basis requiring more information and assurances than s270
- Guernsey funds could private place to institutions in the UK without registration
- Financial advisers could advise their clients to invest into an unregistered Guernsey fund, although from a UK regulatory perspective this would be seen as investment into a Unregulated Collective Investment Scheme (UCIS)
With the advent of AIFMD the UK government repealed s270 of FSMA and introduced a National Private Placement Regime (NPPR) registration process. The NPPR process is one of notification only and requires payment of a fee and the reporting as required under Articles 22 to 24 of AIFMD. However the repeal of s270 of FSMA means that any Guernsey scheme wanting to market to retail investors needs to comply with both AIFMD and the more onerous requirements of s272.
Brexit Option 1 – European Economic Area (EEA): The Norway Model
The first option is to remain a member of the EEA whilst leaving the EU. This would put the UK in the same situation as Norway, Liechtenstein and Iceland.
The problem with this is that it doesn’t solve any of the issues that drove the Brexit vote. The UK would still be subject to each EU directive as and when it is incorporated into the EEA Agreement but would no longer have a voice in negotiating and deciding the content of the directive. It would retain access to the single market but still be subject to the free movement of people and therefore none of the population’s migration concerns would be addressed.
If this option was to be taken then the UK would still be subject to both UCITS and AIFMD and the situation for distributing Guernsey funds into the UK would not change.
Brexit Option 2 – European Free Trade Association (EFTA): The Switzerland Model
By being a part of EFTA the UK could, as Switzerland does, adopt EU directives on a bilateral basis with the EU as a whole. The Swiss public remain opposed to joining either the EU or the EEA.
As at 2010 Switzerland had over 210 separate treaties signed with the EU. All of the agreements that Switzerland signed in 1999 are co-dependent – if any is denounced then they all cease to apply. This means that if Switzerland stops allowing the free movement of people (immigration) from EU member states then most of its agreements with the EU are automatically terminated.
Clearly the UK could negotiate its own package of treaties with the EU, however it is important to note that Switzerland has never been able to utilise the UCITS passport and is treated as a third country under AIFMD. This gives some indication of the fund passport access the UK may expect if it chooses this route.
Brexit Option 3 – Customs Union with the EU: The Turkey Model
The UK could seek to establish a Customs Union with the EU, much the same as the Customs Union between the EU and Turkey.
Whilst there are clear benefits to Turkey from the Customs Union there are also negative factors to such a union, where the signing party (in this case Turkey) has given political and economical powers to the EU. Amongst others:
- Unconditional acceptance to make laws parallel to the new laws made for the customs union by the EU
- Accepting to obey all laws and decisions of the European Court of Justice, without being able to supply judges to that court
- Any treaty with a non-EU country has to be made with the knowledge of the EU or the EU can step in an annul that treaty
Customs Union also relates to the movement of goods and not services. Turkey does not have the right to utilise the UCITS passport and is treated as a third country under AIFMD.
Brexit Option 4 – Comprehensive Economic and Trade Agreement (CETA): The Canada Model
The UK could seek to negotiate a CETA in the same way as Canada has done. The CETA between the EU and Canada still requires approval (Council of the European Union, European Parliament and all 28 current member states) although the negotiations were concluded on 1st August 2014. This indicates that a full agreement may be possible within the two years allowed for Article 50 exit negotiations, although full ratification may take longer.
Again, the bulk of this agreement relates to trade rather than services. Canada is also treated as a third-country for fund passport purposes.
Potential Changes to Fund Distribution
Given the above options it appears highly unlikely that following Brexit the UCITS passport will continue to be available to UK-based funds. For this to be allowed would require changes to the UCITS Directive to recognise third country funds, which given the protectionist stance of many EU member states seems unlikely. Any extension of the passport would likely be seen as an opportunity for other third countries to negotiate UCITS access.
Given that UK retail funds would no longer be eligible, UCITS allows for the possibility of the UK to rewrite the Collective Investment Schemes Sourcebook (COLL) and focus on those areas that the UK considers are essential for retail sales domestically. However, being outside the EU means that the UK no longer has to allow for the recognition of UCITS funds from remaining EU countries for sale into the UK (s264 of FSMA). Why should the UK allow such funds access to retail clients when there is no reciprocity available?
This provides an opportunity for re-opening the recognition of Guernsey Class “A” Schemes in the United Kingdom under a re-constituted FSMA s270. The reasons are clear:
- Reciprocal recognition of UK schemes for sale in Guernsey. Which already exists in Guernsey under The Investor Protection (Designated Countries and Territories) Regulations 1989 – this currently recognises UK Authorised Unit Trusts but could be extended to cover Open-Ended Investment Companies and any other UK retail collective investment schemes
- The “International Capital Flows” report published by KPMG and commissioned by the Guernsey government shows that (as at November 2014):
- Guernsey funds act as a conduit for £25bn in overseas investment into the UK
- Guernsey funds act as a conduit for £27bn in global investment by UK investors
- £1.1bn in Investment Management fees is earned by UK-based managers of Guernsey funds
- UK government and quasi-government investors can invest internationally via tax neutral vehicles in Guernsey thereby maximising return of taxpayers capital
Moving into the realm of alternative investment funds, again being outside the EU gives the UK a chance to re-write the rules under the Investment Funds Sourcebook (FUND). The UK can make its alternative funds more internationally competitive by adopting an opt-in AIFMD regime similar to those in jurisdictions such as Guernsey. This allows for funds aimed both at internal UK investors and non-EU investors to fall outside the AIFMD regime resulting in cheaper streamlined products. This could also allow non-EU funds (such as those in Guernsey) to market under private placement into the UK without being subject to the AIFMD requirements.
For the UK as a third country to sell funds into the EU under the AIFMD passport would require positive assessment from the European Securities & Markets Authority (ESMA) and the third country passport regime itself would need to be implemented by the European Commission. Until the UK has access to the AIFMD passport any marketing of UK-based AIFs into EU countries will need to be done under NPPR. Before NPPR marketing is allowed in each EU or EEA country the Financial Conduct Authority would need to sign a Memorandum of Understanding with the relevant regulator in each EU & EEA country and the country would need to have transposed AIFMD into national law, including Article 42.
Again, the benefits for Guernsey are that selling Guernsey-domiciled funds to institutions in the UK will not necessarily have to be governed by an EU directive (in this case AIFMD). A less formal type of private placement could be utilised without necessarily requiring registration and certainly without the onerous levels of reporting required under Articles 22 to 24. This may reduce the costs for Guernsey funds being sold into the UK, although any fund still selling into the remaining EU/EEA jurisdictions would still have to comply with the Directive.
What are the benefits to the UK of being outside the scope of both UCITS and AIFMD? The simple answer is being outside of an institutionalised straight-jacket. The longer answer is that the UK will be able to put in place whatever regime it wants, and can plan for dealing with the rest of the world. A topic for another time…